What You Need to Know About a Safe Harbor 401(k)

Under these tests, there can’t be a large discrepancy between the groups in terms of what they are depositing into their 401(k) accounts. For instance, with the actual deferral percentage test, or ADP test, if non-highly compensated employees are only putting an average of 4 percent of their income into their retirement plan, highly compensated employees will be limited to depositing 6 percent of their income. The government-required tests also aim to assess whether the account contributions are top-heavy. To do that, the tests compare the fund assets of key employees to those of everyone else. A key employee is defined as an owner or officer of a business. “At the end of the year, do these key employees own more than 60 percent of the plan assets?” Conlon asks. If so, the government requires the company make a 3 percent contribution for all its other employees.

“The testing rules are really to make sure the rank-and-file employees are able to take advantage of the plan the same as the highly compensated employees,” explains Joseph Conroy, author of “Decades & Decisions: Financial Planning At Any Age” and a certified financial planner at the advisory firm Synergy Financial Group in Towson, Maryland.

How Does a Safe Harbor 401(k) Benefit Employers?

With a regular 401(k), a company must pass the nondiscrimination testing every year, however, that process can be avoided by establishing a safe harbor 401(k) plan instead. Plans that follow the safe harbor framework are assured of fulfilling government requirements, Conlon explains. “It will cost a little bit of money, but it will keep you out of hot water,” he says.

Still, it can be cheaper than setting up a regular 401(k). Conroy estimates that a business with 25 employees might pay $1,000 upfront to set up a safe harbor 401(k), but the price for a comparable traditional plan may be $2,250. Safe harbor 401(k) plans offer more than a simplified way to pass nondiscrimination testing rules.

“You’re essentially buying yourself the opportunity to defer more,” says Josh Sailar, an investment advisor with financial firm Miracle Mile Advisors in Los Angeles. That’s because highly compensated owners don’t have to worry about their contributions being capped by ADP testing.

With a safe harbor 401(k), everyone can contribute up to the $19,000 maximum in 2019, and those age 50 and older can make an additional $6,000 in catch-up contributions.

Read: [401(a) vs. 401(k): What Is the Difference?]

How Does a Safe Harbor 401(k) Benefit Workers?

A safe harbor 401(k) also offers significant benefits to workers. “The key difference is that employers have a set minimum contribution,” Stover says. That minimum contribution is how the plans get to bypass the annual nondiscrimination testing imposed on other 401(k) plans.

The government provides several ways for companies to make contributions for their workers. They can choose to provide a nonelective contribution equal to 3 percent of an employee’s income. The other option is to offer matching contributions. Businesses may use several formulas that enable employees to receive contributions of up to 4 percent of their income from their employer.

Another advantage for workers is that employer contributions to safe harbor 401(k) plans are immediately vested. With a traditional 401(k), an employee may have to work a certain number of years before they have full access to this money, but no such lengthy predetermined vesting schedule is in place with most safe harbor plans.

How to Start a Safe Harbor 401(k)

Employers who want to open a safe harbor 401(k) plan should seek out professional guidance. “A third-party administrator is like the accountant for retirement plans,” Conroy says.

Accounting firms and payroll providers have traditionally served as plan administrators, but online solutions such as those offered by Betterment for Business are gaining popularity. Another option is to get assistance from an advisory firm that can determine how a retirement plan fits into the big picture of company finances and goals. “At Miracle Mile, we look at things very holistically,” Sailar says. “We try to develop the plan in such a way that it’s integrated with the overall business plan.”

See: [10 Tips for Rolling Over a 401(k) When You Change Jobs.]

Regardless of whether an accountant, financial advisor or another professional helps set up the plan, its official documentation must indicate it’s a safe harbor 401(k). Existing plans can only be converted to a safe harbor at the start of a new year, and employees must receive an annual notification of their rights and obligations.

A safe harbor 401(k) is a favorite retirement plan for many small businesses. Not only do these savings accounts make it easier for company executives to meet government rules, but they ensure workers receive minimum contributions toward their retirement, making it a win-win for employers and employees alike.