Feeling good about your company’s retirement plan offerings? Now that competition for talent is getting more intense, it might be a good time to review and tighten up. Believe it or not, the median age of the American worker is around 42 years old (U.S. Bureau of Labor Statistics), and this worker likely has more questions about your 401(k) benefits than its younger counterparts.
A 401(k) is a financial safety net for many Americans. So, if your company is included in the 56% of employers that offer a 401(k) (USBLS), you’re off to a great start! But, did you know that there is more than one type of 401(k) plan available? Choosing an alternative setup could provide additional advantages for both your organization and your employees.
Today we are taking a look at the traditional 401(k) and the safe harbor 401(k).
Traditional 401(k)
Many of us are familiar with the traditional 401(k) plan. It allows eligible employees to make pre-tax payroll deductions, called deferrals, to enjoy after their working years. Employers then have the option to contribute a matching amount or a percentage based on the employee’s deferral amount. (The average percentage these days? 4.7%, according to Fidelity.)
In a traditional 401(k), these contributions are often subject to an employer’s vesting schedule, or a waiting period before the company’s contribution belongs completely to the employee. An example of a vesting schedule: after 1 year, an employee is 0% vested; after 2 years, 50% vested; only after 3 years do they become 100% vested. Typically, the longer an employee’s tenure, the more vested they become.
Waiting to reap the benefits of the matching contribution is likely an employee’s least favorite feature of a traditional 401(k). Fortunately for them (and maybe for you) there is another kind of 401(k) that allows them to be immediately vested. It’s called a Safe Harbor 401(k).
What is a Safe Harbor 401(k)?
A Safe Harbor 401(k) is similar to a traditional 401(k) in that pre-tax deferrals are made by employees, but in this instance, employers are required to make contributions to employees’ 401(k) plans and employer contributions are fully vested when made. This is a major benefit for employees. Employers of any size can use Safe Harbor 401(k) plans and they can also be combined with other retirement plans. The benefit for employers is that as long as they meet the requirements for matching contributions, they will not be subject to the complex annual non-discriminatory testing that applies to traditional 401(k) plans.
Employers have the following options for matching contributions to meet the requirement for a Safe Harbor 401(k):
- Basic match: 100% match on the first 3% of deferred compensation plus a 50% match on deferrals between 3% and 5%.
- Enhanced match: Must be at least as generous as the basic match at each tier of the match formula. A common formula is a 100% match on the first 4% of deferred compensation.
- Safe harbor nonelective contribution: 3% (or more) of compensation, regardless of employee deferrals.
What are Annual Nondiscrimination Tests?
Of course, with every 401(k) plan there are rules.
One of the key regulations for traditional 401(k) plans is annual, government-mandated nondiscriminatory testing. These tests, known as the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests, are designed to prove a plan doesn’t unfairly favor certain employees.
These tests analyze the savings rates of highly compensated employees compared to non-highly compensated employees. (A highly compensated employee is someone who earns more than $130,000 annually). Traditional 401(k) funds are also reviewed to assess if a company’s fund is top heavy or, in other words, if most of the account contributions are coming from key employees or highly compensated employees. In this case, a key employee is an owner or officer of a business.
Under nondiscriminatory testing, average contributions made by HCEs can’t be more than 2% higher than average contributions made by non-highly compensated employees. There are consequences for failing NDTs, too. Businesses must take corrective action.
Employers sponsoring safe harbor 401(k) plans must also satisfy certain notice requirements. Each eligible employee must be given written notice of their rights and obligations under the plan. The notice must also describe the safe harbor method in use, how they can make elections, and any other plans involved if applicable.
What are the Limits for a Safe Harbor 401(k)?
Every 401(k) plan type has contribution limits. The limits for 2021 are below (some have increased from 2020).
- The maximum employee deferral limit is $19,500.
- The catch-up contribution limit for employees over 50 is an additional $6,500.
- The maximum contribution limit is $58,000 from all sources (employee and employer).
Again, the traditional 401(k) is subject to annual non-discriminatory testing to check the fairness of the employer contribution, but a Safe Harbor 401(k) exempts the business from these annual tests. For this reason, a Safe Harbor 401(k) is a great choice for small businesses.
Choosing the Best 401(k) for Your Organization
When it comes to choosing a 401(k) plan for your employees, make sure you’re aware of all the options. These are only two, but when you investigate and choose the best plan, you may be able to save your organization work and delight employees in the process.
As you review your benefits mix and retirement offerings, it’s important to make the selection process as easy as possible for employees. If you are looking for a way to educate your employees on the benefits you offer, consider Paycor’s Benefits Advisor.