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Does Your 401(k) Plan Need a Safe Harbor for the Coming Year?

If your company flunks one or more of the tests related to your retirement plan, you could indeed be charged a hefty penalty. The tests measure the average deferral percentage (ADP), the average compensation percentage (ACP), and 401(k) non-discrimination tests for failing to make the minimum contribution amounts for plans considered "top heavy.“

Your third party administrator should ideally steer you away from the danger zone in time for you to make adjustments. However, if your company seems to be flirting with the edge a little too closely, you may want to consider adopting a safe harbor plan. Not that the decision is a slam-dunk. A safe harbor could end up costing you more than you would otherwise need to contribute to a plan.

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Here is a streamlined description of how the ADP and ACP tests work, and the safe harbor formulas (you'll need to consult a professional for additional details).

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The ACP is similar, but looks at employer matching contributions, after-tax employee contributions and certain other amounts generated by forfeitures allocated to 401(k) participants based on their deferral amounts or employer matches.

The ADP test involves comparing the individual employee deferrals of highly compensated employees with everyone else, also called the non-highly compensated employees.

Who is Deemed Highly Compensated?

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Highly compensated employees are those who either:

1. Own at least 5 percent of the company (stock owned by immediate family members is counted towards that 5 percent),

2. Earn at least $165,000 (amounts are adjusted annually), or

3. Own at least 1 percent of the business and earned more than $150,000.

Learning whether you will pass or fail the ADP or ACP test requires first determining the average deferral rate for all highly compensated employees. Do this by adding up their total deferrals (or other amounts for ACP testing purposes) and dividing the sum by their collective salaries.

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Next, the same exercise is performed for the non-highly compensated employees. These comparisons can be made either by:

• using the current year for both employee groups, or

• by comparing the prior year non-highly compensated average deferral rate with the current year highly compensated deferral. This method makes it easier to calculate the necessary corrective action if your current trajectory would cause you to fail the test.

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Here are the limits:

• If the average deferral for non-highly compensated employees is 2 percent or less, the average deferral for highly compensated employees cannot be more than twice that of the rate for non-highly compensated employees.

• If the deferral rate of non-highly compensated employees is between 2 and 8 percent, the highly compensated employees' maximum average must not be more than 2 percent higher than this (for example, if the non-highly compensated average deferral rate is 5 percent; the highly compensated average cannot exceed 7 percent).

• Finally, if the deferral for non-highly compensated employees exceeds 8 percent (which is unlikely), the deferral for highly compensated employees cannot exceed it by more than 25 percent (in other words, the highly compensated rate must be no more than the non-highly compensated rate multiplied by 1.25).

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Highly Compensated Employee Compensation Test Limits

Note: The amount of compensation for highly compensated employees which can be counted in the test is limited to $250,000 for 2013. This means if you defer 5 percent on a $350,000 salary ($17,500), it would be counted as a 7 percent contribution since $17,500 is 7 percent of $250,000. Also, the additional $5,000 in "catch-up" contributions for participants over 50 isn't counted for testing purposes.

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Many 401(k) plans, especially those with employee turnover, are deemed "top heavy" by the IRS. A top heavy plan is generally one in which the assets of "key employees" (similar to highly compensated employees) exceed 60 percent of the plan's total assets. Top heavy plans must contribute as much as 3 percent of non-highly compensated employee salaries to their 401(k) accounts.

Having your plan conform to the safe harbor rules lets you avoid the testing. Using a safe harbor formula generally makes the most sense for top heavy plans or plans which often fail the ADP/ACP tests.

Generally you must adopt the safe harbor design requirements prior to a new plan year (with an exception noted below).

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Safe Harbor Formula Choices

You have two alternative safe harbor requirements to choose from. One is based on your deferral matching formula, and the other, a non-elective contribution to all plan participants.

The non-elective contribution option requires at least a 3 percent contribution to all plan participants, regardless of whether they are currently putting in any of their own money. (Note: That's the same requirement for top heavy plans.) That contribution amount is not pro-rated for employees who join the plan after the beginning of the plan year. This means an employee with a $50,000 salary who joins the plan in at the beginning of the 12th month of the plan year would get the same $1,500 as a long-tenured participant.

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Under the alternative matching contribution formula safe harbor (which of course only helps employees who are putting their own funds into the plan), you have two choices:

1.Match 100 percent of the first 3 percent of deferrals and 50 percent of the next 2 percent of deferrals, or

2.The "enhanced match" option. This consists of a minimum dollar-for-dollar match on at least 4 percent of pay (or 6 percent to avoid penalty if you failed the ACP test).

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If you aren't sure whether you want to go the safe harbor route, you can declare 30-90 days before the beginning of the next plan year that you might opt to become a safe harbor plan in the coming year. But if you then decide to do so, your only formula choice is the 3 percent non-elective deferral amount. Be sure to declare your intention to the IRS and employees within the stated time frame, 30-90 days prior to the end of the plan year.

The IRS website contains a useful page featuring a 401(k) "fix-it guide" that describes remedies for a variety of compliance issues, including screw-ups in performing ADP/ACP and top-heavy tests.

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