Duct Tape Marketing

Investment representatives and retirement service providers will be hailing the new limits as an opportunity for employees to save more money in their retirement plans on a tax deferred basis. Following that advice may be a mistake for highly paid employees and could cost their employer additional fees.

Following the advice, highly compensated employees, with higher discretionary income levels, would increase their contributions. The non-highly compensated employees, with little discretionary income, will maintain their contributions at the current levels. The net result is a failed Non discrimination test (The Average Deferral Percentage Test) with the subsequent refunds to the highly compensated and additional employer fees.

The Safe Harbor

Instead of touting the new plan contribution limits alone, investment representatives need to include the "Safe Harbor" plan design benefits with them.

401k Safe Harbor Benefits

Adopting a safe harbor 401(k) plan design permits an employer to avoid discrimination testing of the rates of employee elective de­ferrals and/or employer matching contributions (ADP / ACP test­ing). The benefit for avoiding testing is maximized contributions for the highly compensated. The safe harbor plan design waives the need for non discrimination testing and permits the company owners or those earning over $90,000 a year to contribute up to $20,500 to the plan on a tax deferred basis. With the 401k Safe Harbor design, the employer matching contribution can also be used to satisfy any top heavy requirements. (A plan is top heavy when more than 60 percent of the assets are held by the owners and key employees. A top heavy plan is required by the IRS to give all eligible plan participants an additional contribution equal to the lesser of one-third of the contribution received by the highest paid key employee or 3 percent of compensation).

Two Types of 401k Safe Harbor Designs.

One type is the safe-harbor non-elective design of 3% of compensation. Generally, a 3% contribution is provided to all employees eligible to make elective deferrals to the plan. The guaranteed contribution requires that a 3% employer contribution be made each plan year, unless the employer amends the plan and removes the provision before the start of the new plan year. The 3% is 100% employee vested.

The other type of safe-harbor design is a matching contribu­tion. There are two options from which to choose, the basic or the enhanced match. The basic safe-harbor matching contribution is defined as a 100% match on the first 3% deferred and a 50% match on deferrals be­tween 3% and 5%. Alternatively, the employer may choose an enhanced match­ing formula equal to at least the amount of the basic match; for example, 100% of the first 4% deferred.

Timing the 401k Safe Harbor Adoption

Safe-harbor 401(k) plan provisions may not be added to an exist­ing 401(k) plan in the middle of a plan year. Instead, the plan must be timely amended to add the safe-harbor 401(k) provi­sions for the next plan year.

In an exception to the timing requirements for giving the safe ­harbor notice, a new 401(k) may adopt a safe-harbor design at the same time that the plan is established, assuming the notice is provided simultaneously. There must be at least 3 months remaining in the plan year to make elective deferrals for a plan to use this provision. An existing profit-sharing plan that is amended to add a 401(k) feature is eligible to use this rule.

Further, a totally new business entity establishing a new 401k plan may have as short as a one-month initial plan year (assuming that the initial year is then followed by the normal 12 month year).

401k Safe Harbor Conditions

The sponsor of a 401k plan using a guaranteed 3% must make that contribution regardless of its subsequent financial condition during that plan year. However, an employer may stop mak­ing safe-harbor matching contributions by providing a notice to the employees. This notice must be given at least 30 days before the contributions are to be stopped. If an employer stops safe-harbor matching contributions before the plan year is completed, the ADP and ACP tests must be preformed for the entire plan year.

Investment representatives hooking the annual plan limits with a "Safe Harbor" plan design will end up providing their clients with three benefits---Higher tax deferred contribution levels for the company owners and highly compensated --- non discrimination testing issues are eliminated--- and any top heavy issues are satisfied as well. -- That's a triple play.