Safe Harbor Plans: Costly When Poorly Designed

May 24, 2017

A safe harbor provision simply means that you will not violate a statute or regulation as long as certain conditions are met. In other words a free pass for nondiscrimination testing for 401(k) plans.

Traditional Safe Harbor Costs

In order for 401(k) plans or other qualified plans to enjoy tax preferred status, they must comply with nondiscrimination testing rules. Through the application of mathematical formulas, plans must demonstrate that they do not discriminate in favor of the owners or highly compensated employees (HCE). For example, in a company offers a 401(k) plan and if the average deferral rate for staff employees is 2% then the maximum the owners and HCE’s can defer is roughly 4%. However, if the plan is safe harbor, the owners and other HCE’s deferral is not limited by the staff’s level of participation. They could defer as much as $17,500, but to qualify for this free pass, the employer must be willing to commit to a specific match or a flat 3% of pay for everyone who is eligible. Either one of these safe harbor provisions could be very expensive for employers who have a poorly designed 401(k) plan.

Closely held businesses typically sponsor a 401(k) plan for one of three reasons:

  1. To allow owners and other key employees to save taxes
  2. To provide a vehicle for employees to save for retirement
  3. All of the above

New Alternatives

If the objective is for the business owner to save taxes, then the staff cost for the 401(k) plan should be equal to or less than the tax savings. Plan design strategies can be deployed to optimize the tax savings while minimizing staff cost.

Section 410(b) of the Internal Revenue Code permits a plan to remain qualified if it includes (covers) at least 70% of the eligible employees. This provision provides significant leeway when designing a safe harbor plan for closely held businesses.

A study by the American Benefits Institute found that on average 73% of eligible employees participate in their employer’s 401(k) plan. It has been our experience that the participation rate is even lower in closely held businesses. This is a very important statistic when seeking to optimize a plan design.

If only 70% of the eligible workforce has to be included in the plan, and if only 73% on average find a plan beneficial to them, then why not only include those who see its value? This approach doesn’t restrict the owner or other key employees from maximizing their contributions, but it does allow the employer to limit the potential cost by excluding groups of employees.

Objective Match

Retirement Vehicle

For the employer whose primary objective is to offer a vehicle for employees to plan for retirement, a safe harbor 401(k) plan eliminates non-discrimination testing so highly compensated employees can defer the maximum.

Minimizing Taxes

Employers seeking the maximum utility from a 401(k) plan may want to minimize taxes for the owner and other key employees, and provide a means by which everyone can save for retirement. A properly designed safe harbor plan, when paired with other features such as additional matching contributions, profit sharing and cash balance contributions, provides the general framework for the optimal balance between tax savings and retirement readiness.

Retirement Opportunity

Regardless of status – highly compensated, non-highly compensated, or owner – everyone should have the same opportunity to save for an adequate retirement. A properly designed plan can include safe harbor provisions but with controlled staff cost. Plan sponsors, and consultants, who think outside the box can enjoy the benefits of greater tax savings and higher contributions while balancing staff cost.

by Richard Phillips AIF, ERPA, CPC, QPA, QKA

By Chandler Julian, CPA, QKA, AIF

Chandler serves as the firm's Chief Financial Officer.

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