Making the Most of Your 401(k) Plan (March 1999)

Article
March 1999

Making the Most of Your 401(k) Plan

CPA firms have a valuable new design option for their 401(k) plans. The new approach, which became effective Jan. 1, is called a safe harbor plan. It should work well in most CPA firms, from those with only one or two professionals and a few staff, up to firms with as many as 200 to 300 professionals and staff. The key to the new design is the ability to use the same dollar contributions to satisfy multiple requirements. First, let’s look at the basic rules for typical CPA firm 401(k) plans—before the safe harbor:

Pre-Safe Harbor Rules

Deferrals to a 401(k) plan must pass a special non-discrimination test, the ADP test, which places a limit on the percentage of pay the higher-paid CPAs (HCEs) can contribute compared to the non-highly paid employees (NHCEs). (Generally speaking, an HCE is someone who makes more than $80,000 per year.) If the plan fails, the two most common ways of correcting the problem are for the plan to return a portion of the deferrals to the HCEs or for the firm to make a contribution for the benefit of the HCEs. (These additional contributions are referred to as QNECs.)
Since the plans for most CPA firms are top-heavy (i.e., more than 60 percent of the assets are in the accounts of the key employees—generally speaking, the partners or shareholders), the firm must make a minimum 3 percent of pay contribution for all non-key employees, i.e., all other employees of the firm, including non-owner HCEs. The dollars contributed as QNECs can be counted toward the 3 percent top-heavy minimum.
If the plan is also cross-tested (which permits employer—that is, the firm’s profit sharing—contributions to be allocated disproportionately in favor of some or all of the HCEs based on age and compensation), the firm must make a contribution for the benefit of the NHCEs, typically in the range of 3 percent to 5 percent of pay. To complicate mattters, while the top-heavy contributions count for cross-testing, QNECs do not. Thus, they cannot be used to support the large profit sharing contributions for the firm’s senior members.
Thus, if the plan fails the ADP test, is top-heavy and cross-tested, an accounting firm usually winds up contributing a substantial amount for the NHCEs.

The New Rules
Now let’s look at a safe harbor plan. A safe harbor 401(k) plan will automatically pass the ADP test if the firm contributes 3 percent of pay for all eligible NHCEs (even those who don't defer and including the NHCE professionals). This amount must be fully vested. This 3 percent contribution can also be used to meet the top-heavy requirements. In addition—and this is what can make the safe harbor so attractive—the same 3 percent can be counted for cross-testing. In essence, the same dollars can be counted for three different purposes—which is sometimes called “triple dipping.” This usually reduces the cost of the plan for the staff employees, while often increasing the benefits of the senior members of the firm. In the typical CPA firm, a safe harbor 401(k) plan will allow the firm's senior members to receive a $20,000 profit sharing allocation—plus their own $10,000 deferrals—for an annual total of $30,000, at a cost of 3 percent of pay for the employees and without any discrimination testing.

What Are the Negatives?

First, the 3 percent contribution has to be made for all eligible NHCEs, including the NHCE professionals for whom you may not have been contributing in the past. For many CPA firms, this may be the biggest detriment. Some CPA firms have excluded their NHCE professionals—typically the younger accountants—from participating in the 401(k) plans in the past, which can be done in non-safe harbor 401(k) plans.
Second, the firm’s contribution has to be 100 percent vested, so that if employees leave, there are no forfeitures that can be used to offset future employer contributions.

To implement a safe harbor design for an existing 401(k) plan, the document must be amended, and notice of the safe harbor must be given to the eligible employees. For existing plans to use the safe harbor in 1999, the notice must have been given by March 1. (There are special rules for new plans.)

To determine whether a safe harbor plan makes sense, you must calculate the differences in costs and benefits between the current plan design and the safe harbor. We believe the safe harbor plan will provide a cost savings—and perhaps a benefit increase—for most accounting firms.

Learn more about R&R related practice areas:
Employee Benefits