Small-business owners still weighing the pros and cons of a retirement plan might want to consider a Safe Harbor 401(k) plan.
But they shouldn’t wait too long, because the deadline to put one in place for 2013 is Oct. 1 and the paperwork to set one up can take one to two weeks — so time is of the essence.
The Safe Harbor enables small-business owners and any highly compensated employees to make the maximum contribution ($17,500 for those under 50 years of age; $23,000 if over 50) either tax-deferred or after tax in the Roth 401(k) regardless of income in 2012 and on-going.
Craig Hoffman, general counsel and director of regulatory affairs for the American Society of Pension Professionals and Actuaries, said that while Safe Harbor plans have been around for a while, “the changes made in the 2001 EGTRRA (Economic Growth and Tax Relief Reconciliation Act) significantly improved on the design.”
“They’ve been very popular with plan sponsors because they know that, for the cost of a modest … contribution that can be made on a matching basis, first, they’re encouraging their employees to participate, and, second, they avoid the need to go through the testing process, which is administratively burdensome.
“It’s an easy-to-run plan, and the employees benefit (as well as the employer),” he said.
The Safe Harbor 401(k), which can be used by either large or small businesses, really shines for small-business owners.
It allows business owners to avoid IRS nondiscrimination testing requirements that apply to standard 401(k) plans — the so-called “top-heavy rules,” said Hoffman, that were “an anachronism from the early 1980s that only applied to plans that primarily benefit owners of businesses.”
Prior to the EGTRRA action, calculations were required to determine whether the total account value of owners, together with key, or highly compensated, employees exceeded 60 percent of the total account value of all the employees in the plan. If so, that determined the matching contribution level required of the employer.
There were three problems with this approach: first, an employer wouldn’t necessarily know whether a plan was top-heavy until the determination date — which, for new plans, is the last day of the current plan year; in other words, not until the first plan year was completed.
Second, a plan determined to be top-heavy requires the employer to make a contribution for all non-highly compensated employees that is equal to the lesser of 3 percent of compensation or a percentage equal to the highest contribution rate of any highly compensated employee.
And third, according to Christopher Hoyt, professor of law at the University of Missouri School of Law in Kansas City, highly compensated employees who “are owners of more than 5 percent of the business, and the top 20 percent of employees who earn over $115,000” aren’t free to contribute as much as they might like toward their retirement in a standard plan.
A standard plan, Hoyt explained, “is subject to ‘ADP’ (average deferral percentage) testing, which limits the amount that the highly compensated can put into their accounts. Their contribution is based on the percentage of pay that the non-highly compensated put into their accounts.
Hoyt gave an example: If a non-highly compensated employee contributed 1, 2, or 3 percent to the plan, a highly compensated employee (or the business owner) would be allowed only to contribute 2, 4, or 5 percent instead of the IRS-allowed max.
But EGTRRA “carved out an exception,” Hoffman pointed out. Not only do employers not have to go through discrimination testing, but employers and highly compensated employees can contribute more money for their own retirements. “Small employers love it. … The top-heavy exemption is a very strong selling point for small businesses,” Hoffman said.
There are actually “two different types of safe harbor plans,” said Rob Austin, director of retirement research at Aon Hewitt.
The EGTRRA carve-out is one, and the second “was just introduced with the 2006 Pension Protection Act and came into being in 2008. … From our data, we find a total of 35 percent of clients have a 401(k) safe harbor plan. Eleven percent of these use the pre-PPA formula, and 24 percent use the newer one.”
There are pros and cons to each, as Austin explained.
“The pre-PPA formula requires employers to do one of two things: give everybody at least a 3 percent (contribution) of (their) pay into (the) plan, or have a matching contribution: 100 percent of the first 3 percent that an employee defers, plus 50 percent of the next 2 percent,” he said.
Those contributions are immediately vested, he added, which will be unpopular with companies experiencing high turnover.
Then there’s the PPA formula, which incorporates auto-enrollment. The employer contribution is lower, too. “That’s more appealing,” said Austin. “It allows at most a two-year vesting requirement. If there’s high turnover in the first couple of years, (the employer isn’t on the hook for all those small balances).”
Of course, no plan is perfect. Austin pointed out that with the PPA formula’s auto-enrollment, everyone has to be included, even if they’ve been working for years without participating. “An employer might have had 60 percent participation and then might see participation go up to 90 percent; all of a sudden their costs have escalated quite a bit.”
Safe harbor has another advantage, Austin said. A non-safe harbor plan that fails discrimination testing will force refunds of employee contributions, which makes employees liable for additional taxes. Safe harbor eliminates that risk.