Safe-harbor 401(k)s offer alternative for small business

Selecting the retirement plan that meets your needs and those of your employees can be difficult. It is important to look at the details to ensure that the plan you select is the most appropriate.

For example, many employers who currently maintain 401(k) plans are disappointed when they realize that, at the end of the year, they must refund contributions to highly compensated employees because of low or reduced participation levels from the rank-and-file employees.

To help business owners avoid this situation, a safe-harbor 401(k) may serve as a better alternative to help enhance contributions for the highly compensated employees, while keeping overall administration costs in check.

A safe-harbor 401(k) is a retirement plan that allows highly compensated employees to make salary deferral contributions up to the designated limit for a given year ($13,000 for 2004), regardless of the participation level of regular employees, and as long as the employer commits to a certain level of contributions.

To understand the benefits of the safe harbor 401(k), you must first understand annual discrimination testing applicable in traditional 401(k) plans. Employers must perform two tests to ensure the amounts deferred by employees and the employer’s matching contributions do not discriminate in favor of the business owners and other highly compensated employees.

The Actual Deferral Percentage Test ensures that the rate of deferrals for highly compensated employees is not excessive compared to that of nonhighly compensated employees. If a retirement plan fails this test, the employer must refund contributions to highly compensated employees or make contributions on behalf of nonhighly paid employees.

The Actual Contribution Percentage Test applies to the rate of matching contributions on behalf of highly compensated employees versus the average employees, in much the same way as the Actual Deferral Percentage Test.

The advantage of a safe-harbor 401(k) is that it does not require the complicated discrimination testing. Instead, the plan must meet both contribution and notification requirements, and the employer must make a minimum fully vested contribution to the plan using one of the following methods:

• Matching contributions for each eligible participating employee. Under the match formula, the employer will provide the safe-harbor contribution to any employee who elects to defer, through salary deferrals, into the plan. This method has basic and enhanced match formulas. The basic match formula is defined as a 100 percent match on the first 3 percent deferred and a 50 percent match on deferrals between 3 percent and 5 percent of salary. The enhanced match formula allows the plan sponsor to tailor the formula used to match. Nonetheless, it must be equal to at least the amount a participant would receive under the basic match.

• Nonelective contributions of 3 percent of pay for all eligible employees. Under the nonelective formula, the employer will provide a minimum of 3 percent in safe-harbor contributions to all eligible employees, regardless of their participation in the plan.

All eligible employees must receive written notices describing the applicable safe-harbor provision between 30 and 90 days before the beginning of the plan year. This notice must be provided for each year the plan will be a safe-harbor plan.

Safe-harbor 401(k) plans may be an attractive option for small businesses and their employees. A financial consultant can help sort through the options to find the best plan for an individual business.

Timothy Reese is senior vice president, investments, with A.G. Edwards & Sons Inc.