The New 401(k) Plan Safe Harbor Design

By Fred Reish and Bruce Ashton

Beginning this year, employers have a new alternative for satisfying the 401(k) non-discrimination requirements: the safe harbor in Code Section 401(k)(12). While the new safe harbor design is available for plans of all sizes, it will be most useful for top-heavy plans of employers with a significant number of highly compensated employees, such as law firms, medical groups, investment advisors, engineering firms, and other service businesses with professional or technical workforces.

The employer has two options for meeting the safe harbor. The first is a matching contribution for rank-and-file employees (non-highly compensated employees, or NHs) who defer to the plan during the year. The match must equal 100% of the deferrals up to 3 percent of pay plus 50 percent of the deferrals on the next 2 percent of pay. The second option is to make a contribution equal to 3 percent of pay for all eligible NHs, whether or not they defer. In both cases, the contribution must be 100 percent vested and must be made for all eligible employees, even if they work fewer than 500 hours and/or are not employed on the last day of the plan year.

We believe the second option—the 3 percent contribution—will be chosen by top-heavy plans, and the rest of this article focuses on that option.

In return for the 3 percent contribution, the plan will not have to test for the ADP—because it is deemed to pass. This means both cost savings and simplification, because the plan won't have to return deferrals to the high-paid (highly compensated employees, or HCs) or make QNECs for the NHs.

In addition, the 3 percent contribution (but not the match) can be used to satisfy the top-heavy requirements for the NHs. If the employer has non-key HCs, it still will need to make a top-heavy contribution for them, but it would have to make that contribution in any case. And, finally, the 3 percent contribution (but not the match) can be used to cross-test—to allocate employer contributions on the basis of age and compensation, which has the effect of increasing the contributions for some or all of the HCs.

Thus, in a top-heavy, cross-tested plan, the safe harbor permits the same contribution to be counted three times (unlike the general rule for non-safe harbor plans, where QNECs help the plan pass the ADP test and meet top-heavy requirements, but can't be counted for cross-testing).

To use the safe harbor, employers must notify their employees before the start of the plan year. Because it's new this year, however, the notice could have been given for existing 401(k) plans at any time on or before March 1 if the plan year begins on or before April 1. For new pans (and for profit sharing plans adding a 401(k) deferral), the notice can be given up until the first day of the plan year (but the first plan year can begin no later than October 1 for a calendar year plan).