In the past, many business owners have felt the 401(k) plan failed to meet their needs. First, the costs for administrative, compliance testing and recordkeeping could be prohibitive.
Second, the nondiscrimination requirements of the IRS restricted the amount that could be set aside by the business owner and other key executives.
Simultaneously the top-heavy rules could require the employer to make contributions to the plan without receiving much, if any, benefit for the employer. Thus, a significant number of business owners found 401(k) plans to be expensive and unsuitable.
The answer for these companies became a profit-sharing plan, in which the entire burden of funding fell on the shoulders of the employer, or a SIMPLE, in which contributions were severely limited.
In 1998, a provision was added to the IRS code that allows employers to offer a 401(k) plan that incorporates a standard, nondiscretionary employer contribution formula and thus removes the need to satisfy nondiscrimination and top-heavy testing. In other words, highly compensated employees are allowed to contribute the maximum ($13,000 in 2004) without regard to the amount contributed by nonhighly compensated employees.
They are also eligible to receive the employer contribution, which may, combined with their own deferral, in aggregate be more than the $13,000 limit. If a participant is 50 years of age or older, a special "catch-up" provision allows for an additional $3,000 contribution for a total of $16,000.
This is a significant increase over the $9,000 contribution limit for SIMPLE plans in 2004.
Employers establishing a safe harbor 401(k) have two options for making the nondiscretionary contribution. Both require the contributions be fully vested, although they may be limited to full-time employees who have completed one year of service and attained age 21. The method chosen is dependent upon the specific circumstances of the employer.
* Matching contribution The employer matches 100 percent of employee deferrals up to 3 percent of compensation, and the next 2 percent of compensation deferred is matched at 50 percent. This equates to a 4 percent match for an employee who defers 5 percent or more of their compensation.
* Nonelective contribution The employer contributes 3 percent of employee compensation to the plan regardless of participation.
One of the most significant benefits of the safe harbor plan is that the plan sponsor can calculate the total contribution that will be required in a given year, eliminating surprise end-of-year required contributions. In addition, the plan sponsor can choose to make discretionary contributions to the plan each year over and above the safe harbor contribution.
These can be cross-tested, Social Security integrated or traditional profit-sharing. A vesting schedule can be applied to these contributions in order to reward long-term employees.
Since the safe harbor 401(k) plan is a qualified retirement plan, it retains all of the beneficial characteristics of other qualified plans. Assets are exempt from all personal creditors, account balances are transferable to other tax-deferred vehicles, and loans as well as hardship distributions are available.
As these plans have become more popular and widely utilized, there has been a gradual reduction in costs associated with their implementation and administration. Safe harbor 401(k) plans are no longer cost-prohibitive for most employers, and have become a great alternative for sponsors who wish to eliminate discrimination testing in their plan, as well as give their employees the opportunity to participate in their own retirement planning.
It may be time to re-evaluate your company's plan.
Blake Flood serves as vice president of investments for Consolidated Planning Corp. in Atlanta. His responsibilities include securities analysis and selection, as well as portfolio construction. He also manages the company's pension and profit-sharing consulting practice. Reach him at firstname.lastname@example.org. Maggi M. Heffernan, CPC, is president of Applied Financial Concepts Inc., a consulting and administration firm for qualified retirement plans. Her expertise is designing and maintaining all types of retirement plans for sole proprietors, partnerships and corporations. Reach her at (770) 641-1429.