Client Question: Safe Harbor Employer-Sponsored Retirement Plans

June 5, 2024

We’ve talked about the term Safe Harbor before (in regards to estimated tax payments – you can revisit that post here). This week, a client reached out regarding another type of Safe Harbor.

She said her friend had brought up the concept of Safe Harbor retirement plans and she wondered not only what they were but whether her prior (and future) employer had such plans. This is a great question so let’s dive in!

Employer-Sponsored Retirement Plans

Employer-Sponsored Retirement Plans (known commonly by their associated tax code paragraph such as 401k and 403b plans but can also include profit sharing plans and others) came on the scene around 1980. Prior to that time, many corporations would assist their employees in retirement by providing pensions (ie: ongoing income stream post retirement). The advent of these new type of plans shifted much of the responsibility of saving for retirement onto the employees. These plans are set-up by companies (ie: Employer Sponsored) and let employees defer a portion of their earnings into the plans, without paying income taxes on those funds. Employers could also choose to offer some level of matching contribution to help employees further prepare for retirement and incent their participation.

Potential for Discrimination

As with most financial products and solutions, there are ways they can be structured to benefit some individuals more than others. Retirement plans are no exception. The Federal Government does not want retirement plans to unfairly benefit higher paid employees (who likely have more income to defer and can therefore save more on taxes and earn a higher match) or discriminate against lower-paid employees (who may not be able to put as much away and therefore will save less and/or earn a lower match).

These higher earners are referred to as highly compensated employees (HCE) by the IRS. Retirement plans must undergo annual testing to determine if contribution levels are excessively skewed towards HCEs known as nondiscrimination testing. If a plan fails the nondiscrimination testing, the employer must take immediate corrective action by either refunding contributions of HCEs or make contributions to non-HCEs to equal things out.

Safe Harbor Retirement Plans

The term “safe harbor” is used in many scenarios (see above – tax payments). At a high level, the term refers to actions one can take that will be deemed to be acceptable (and an automatic non-violation of a certain rule or requirement). Applied to retirement plans, the Safe Harbor rule exempts the sponsoring employer from the annual non-discrimination testing described above.

In order to meet Safe Harbor status for a retirement plan, the sponsoring employer has to adopt certain plan features that allow for more equality in contributions. These provisions include immediate vesting in employer contributions and an annual notice to employees. Perhaps most importantly, in order to meet Safe Harbor, there are minimum employer contribution amounts that must be made to the plan. For employer contributions, there are two options to choose from:

a) The plan sponsor (ie: the company) can provide a 100% match to pretax contributions made by non-highly compensated employees on 3% of their pay, plus a 50% match on the next 2% of pay on their contributions. If the employee contributes at least 5% of their pay, the company will end up matching 4%

b) The plan sponsor can automatically contribute 3% of pay to the retirement accounts of all non-highly compensated employees, regardless of whether those employees contribute to their accounts

Employer’s Option

Whether or not an employer-sponsored retirement plan opts to be a Safe Harbor plan is at the discretion of the employer. It’s clear that Safe Harbor contributions will benefit employees but of course, there is a fixed cost to employers for those contributions that some smaller companies simply can’t afford on an ongoing basis. Any company offering a retirement plan needs to weigh the pros and cons of the nondiscrimination testing and the Safe Harbor requirements.

You can easily determine if your company’s plan is Safe Harbored by requesting the Summary Plan Description from your HR department which will outline the provisions and structure of your plan. Further, if it is a Safe Harbor plan, your HR department will be required to give you an annual disclosure on how the plan is meeting Safe Harbor provisions.

Employer-sponsored retirement plans are a key component to the American retirement system. If you are an employee, it is imperative that you understand the inner workings of your company’s plan and take steps to maximize your benefits under the plan.

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