Safe-Harbor 401(k) Plans- Toscano & Ardito CPA, serving North Andover MA, Portsmouth NH and all New England

Safe-Harbor 401(k) Plans

October 2007

The benefits of 401(k) plans are widely known: these plans allow workers to defer some current income and the tax on that income. Earnings on the untaxed income also escape current tax. The deferred tax is due when money is withdrawn from the plan.

Build a safe harbor
The maximum 401(k) contribution in 2007 is $15,500, or $20,500 for workers at least 50 years old. However, if a company's lower-paid workers don't defer enough income, highly compensated employees might not be able to reach those limits. 401(k) plans are subject to two tests: the first applies to pretax contributions and the second applies to aftertax and employer matching contributions. These tests are intended to prevent discrimination in favor of highly compensated employees.

In some cases, higher-income workers might be shut out altogether from a 401(k) contribution. If this issue might be a concern at your company, consider a safe-harbor 401(k) plan. With such a plan, highly compensated employees can maximize their contributions, even if nondiscrimination tests can't be met. To shelter in a safe harbor, employers must make certain minimum contributions.

There are two ways to proceed:

The 4% solution. One tactic is for a company to match each worker's contribution at 100% for the first 3% contributed and 50% for the next 2%. Assuming a worker contributes at least 5% of his compensation, the company's matching amount equals 4% of the workers compensation. Say a worker who earns $40,000 per year contributes $2,000 to her 401(k) account. The company must match at least $1,600 (4% of $40,000).

If the company meets that condition, all of it's highly paid employees can maximize their 401(k) contributions. In addition, the company can match up to $9,000 per year for each of its highly paid employees. The $9,000 maximum match is 4% of $225,000, which is the most compensation that can be considered in 2007 when figuring a retirement plan contribution.

The 3% solution. The other tactic is for the company to contribute 3% of pay for each eligible worker, regardless of whether he or she makes a 401(k) contribution. Suppose another employee also earns $40,000 per year but doesn't put anything into his 401(k) account. The company could contribute $1,200 (3% of compensation) to a 401(k) account for him. The employer's contribution would be the same if the worker earning $40,000 made a $1,000 contribution, a $500 contribution, or no contribution at all.

Again, highly compensated employees could maximize their 401(k) contributions. In addition, the company contribution could be as much as $6,750 apiece - 3% of $225,000 - for those earning that much or more.

Additional requirements
Companies must use one of the two contribution methods described above to qualify their plan as a safe harbor 401(k). Other requirements may also apply.

All contributions must be 100% vested immediately. That includes employee contributions, employer matches, and any investment earnings. Thus, employees can take all the money in their accounts whenever they leave the company. In addition, eligible employees must receive a written notice each year. These notices, circulated at least 30 days before the start of the plan year, must spell out employee rights and employer obligations.

(Reprinted from the October 2007 CPA Client Bulletin; a monthly publication of the AICPA)

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