Recent Publications
401k Plans Have "Safe Harbor"
by Darrell A. Lindman
Without question, 401(k) plans have become the most popular retirement plan in the United States. If your business has not already adopted a 401(k) plan, what are you waiting for? Perhaps you have heard horror stories about the complex nondiscrimination tests applicable to 401(k) plans. These nondiscrimination tests compare the average rates (stated as a percentage of the employee's annual compensation) of salary deferral contributions (the ADP test) and matching contributions (theACP test) made with respect to highly compensated employees with the comparable rates for the business's nonhighly compensated employees. For 2000, a highly compensated employee is an employee who owns five percent or more of the business, or who during 1999 earned more than $80,000. A 401(k) plan that fails these nondiscrimination tests may be forced to return the excess salary deferral contributions made by highly compensated employees and distribute the excess matching contributions made on behalf of highly compensated employees within specified time periods following the end of the plan year or risk sanctions, including plan disqualification. As the result of recent changes in the law, it is no longer necessary to perform these complicated nondiscrimination tests for those 401(k) plans that commit to a safe harbor design. Retirement plans that meet these safe harbor provisions will automatically satisfy the 401(k) nondiscrimination tests. By using a safe harbor design, your highly compensated employees will be able to make salary deferral contributions of up to $10,500 per calendar year (the 2000 limit), without regard to the amounts of salary deferral contributions made by your nonhighly compensated employees.
A 401(k) plan can come within the safe harbor if a basic level of safe harbor matching contributions or nonelective employer contributions are made to the accounts of all eligible employees (those who have satisfied the plan's minimum age and service requirements). The safe harbor matching contributions formula requires that a matching contribution be made for each eligible employee in an amount equal to 100 percent of the employee's salary deferral contributions that do not exceed three percent of the employee's annual compensation, plus 50 percent of the employee's salary deferral contributions to the extent they exceed three percent, but do not exceed five percent, of the employee's annual compensation. If all eligible employees contribute five percent or more of their compensation to the 401(k) plan, the employer will have to make matching contributions equal to four percent of the eligible employees' total compensation. In lieu of making matching contributions, an employer may prefer to make nonelective employer contributions which are not conditioned on any level of employee salary deferral contributions. The safe harbor nonelective employer contribution formula requires a nonelective employer contribution to the 401(k) plan in an amount equal to three percent of each eligible employee's annual compensation. This three percent employer contribution can also be applied to satisfy the top-heavy minimum contribution requirement, if the plan is top-heavy. All safe harbor matching contributions and safe harbor nonelective employer contributions must be 100 percent vested when made (employees can never forfeit these amounts), and they must be subject to the distribution restrictions applicable to employee salary deferral contributions. These restrictions require that the contributions not be distributed to the employee prior to the earlier of the employee's death, disability, attainment of age 59½, or one of certain other limited events, but not including distribution on account of hardship. Additionally, the safe harbor matching or nonelective contributions cannot be conditioned on the employee completing a minimum number of hours of service (such as 1000) or on the employee being employed on the last day of the plan year. To take advantage of the safe harbor design, each eligible employee under the plan must be given a notice which contains specific information pertaining to the plan, including, but not limited to, the safe harbor matching or nonelective employer contribution formula used under the plan, a description of any other contributions that may be made under the plan, how to make salary deferral contributions, a description of the periods in which deferral elections can be made and changed, and withdrawal and vesting provisions applicable to contributions under the plan. Generally speaking, this notice must be given at least 30 days and not more than 90 days before the beginning of each plan year. Under a special transition rule, an employer adopting a 401(k) safe harbor design for the first time has until May1, 2000, to notify its employees that the plan will rely on a 401(k) safe harbor method for the 2000 plan year.
By giving notice to its employees that it intends to use a safe harbor for a plan year, an employer is not committed to continuing the safe harbor design for future years. In fact, under recent IRS guidance, an employer can give a subsequent notice for the same plan year which discontinues the safe harbor design going forward and reverts back to the normal nondiscrimination tests.
In this tight labor market, employees expect prospective employers to offer a 401(k) plan. I urge you to consider such a plan for your business. Give your employees the vehicle they need to provide for a secure retirement. If you already have established a 401(k) plan, consider whether a safe harbor design would be beneficial to your business and to your employees.
If you have specific questions about 401(k) plans, feel free to contact one of our employee benefits attorneys: DarrellLindman at dlindman@fraserlawfirm.com or Beth Latchana at elatchana@fraserlawfirm.com.
