Safe Harbor 401(k): Designed with an End in Mind

Last week, we talked about reasons the safe harbor feature in a 401(k) is like everyone’s favorite card in Monopoly—a “Get Out of Jail Free” card, only for 401(k) plans. It gives a free pass on a couple of important 401(k) non-discrimination tests and alleviates certain penalties associated with failing them (i.e., corrective contributions or corrective refunds). But is doesn’t stop there; there are many other benefits:

  • Ease: It takes the headache of complex non-discrimination testing for 401(k) deferrals off the table;
  • Predictability: It ensures maximum salary deferrals for the highly compensated employees despite possible low participation of the rank-and-file participants;
  • Savings: In many cases, it reduces the minimum contribution employer is required to make for the rank-and-file employees while providing maximum to key players;
  • Efficiency: Since most plans sponsored by small businesses are top-heavy, i.e. attributing more than 60% of plan assets to key employees, special minimum funding requirement apply. Safe harbor provision fulfills this requirement for most top-heavy plans.

Putting It Together

Steve Jobs said, “Design is not just what it looks like and feels like. Design is how it works.” So, let’s take a look at a case study that demonstrates the many safe harbor 401(k) advantages:

Meet Susan. Susan is a successful physician with an internal medicine practice. Her husband, Tom, is a recently retired executive who focused his second career on helping his wife run her 5-employee office. Following recommendation of their advisor, the couple asked us to review their retirement plan.

One of the items that immediately came to our attention was the fact that the plan relied on 401(k) testing to determine the amount of 401(k) salary deferrals that Susan and Tom could make. Because employee deferrals were relatively low, their ability to defer was impaired and cost them annually about $6,500 in unnecessary taxes. In addition, in a number of years, when the 401(k) test failed, the owners had to reverse a portion of their deferrals or make additional 100%-vested contributions for the employees. Reversal of deferrals meant the owners were unable to maximize their funding for the year in which the deferral test failed; additional contributions for the employees meant that the plan’s efficiency was not optimized.

Old Plan

 

Salary

401(k) Deferral

Profit Sharing

Total

Susan

$255,000

$15,657

$35,343

$51,000

Tom

$35,000

$0

$1,750

$1,750

$15,657

$37,093

$52,750

Employee 1

$25,276

$2,000

$1,301

$3,301

Employee 2

$19,771

$600

$1,020

$1,620

Employee 3

$51,500

$1,500

$2,652

$4,152

Employee 4

$16,404

$0

$845

$845

Employee 5

$73,000

$5,000

$3,759

$8,759

$9,100

$9,577

$18,677

 

To prevent failing the 401(k) test, Susan and Tom were able to save $52,750 for retirement with a required contribution of about $9,600 to their employees. While they were happy with the level of funding provided to their employees, they wanted more predictability, simplicity, and opportunity to maximize their contributions.

We recommended that Susan and Tom amend their 401(k) plan to incorporate the 3% safe harbor non-elective contribution to bring more stability to their plan and to allow Tom to maximize his salary deferrals, thus increasing the couple’s total funding. Because this safe harbor contribution can be included as a part of non-discrimination testing for profit-sharing contributions, it was a matter of shifting a portion of the profit-sharing dollars and designating them as safe harbor contributions:

New Plan

Salary

401(k) Deferral

Safe harbor

Profit Sharing

Total

Susan

$255,000

$17,500

$7,650

$25,850

$51,000

Tom

$35,000

$17,500

$1,050

$5,700

$24,250

$35,000

$8,700

$31,550

$75,250

Employee 1

$25,276

$2,000

$758

$543

$3,301

Employee 2

$19,771

$600

$593

$427

$1,620

Employee 3

$51,500

$1,500

$1,545

$1,107

$4,152

Employee 4

$16,404

$0

$492

$353

$845

Employee 5

$73,000

$5,000

$2,190

$1,569

$8,759

$9,100

$5,579

$3,998

$18,677

The Bottom Line

  • Safe harbor allowed Tom to maximize his deferralsincreasing owner contributions to $75,250;

this helped Tom and Susan realize $6,500 of additional tax savings;

  • The potential for 401(k) test failures was eliminated because of the free pass afforded by safe harbor;
  • Plan efficiency was increased; and
  • Because a portion of the profit-sharing dollars was reallocated as the safe harbor contribution, minimum required contributions for the employees remained the same.

Many Businesses Benefit from the Safe Harbor 401(k) Design

The ideal candidates for this plan are businesses with at least one rank-and-file employee who:

  • are interested in a new 401(k) Plan for their business;
  • are setting up a Defined Benefit/Cash Balance and 401(k) combination plan;
  • have an existing Profit Sharing plan and would like to better manage benefit costs;
  • have an existing Defined Benefit plan and are interested in adding a supplemental 401(k) Plan to  increase their tax-deductible contributions

Turn-key investment platforms available through our alliance partners will help you implement a solution to fit your client needs. First Allied retirement sales consultants are available to assist in identifying the right fit.

A Word on Deadlines

The October 1 deadline will apply to those clients who want to add a safe harbor 401(k) plan to an existing defined benefit plan, or establish a combination 401(k)/defined benefit plan for the plan year ending December 31, 2013.  Calendar-year clients have until December 31 to establish their defined benefit plans for 2013.

As always, your First Allied Retirement Services subject matter experts are ready to help. Call us at 888-926-0600 or send a message to pensions@firstallied.com.

 

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