How Do Safe Harbor 401(k) Plans Work?

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A Safe Harbor 401(k) plan enables all employees to receive an employer contribution. This, in turn, allows businesses to avoid the yearly IRS discrimination testing. This is because the plan is not subject to the yearly nondiscrimination tests that the traditional retirement plan goes through. The IRS wants every single employee to use 401(k) retirement plans. It conducts routine checks to make sure that the highest-paid employees don’t max out their retirement contributions for the year, while other employees contribute very little amounts. The main goal of the IRS is to see every employee taking advantage of the plan, not just the highest-paid employees only.

Therefore, the IRS tests every single retirement plan to ensure that the average contributions made by highly paid employees do not surpass those of other employees by more than two percent. Business owners can opt to use Safe Harbor 401(k) plans to avoid experiencing compliance issues and using money to meet the IRS test.

How the plan works

If the IRS believes that a particular retirement plan contribution is excessive, it will reject the plan. If the employer does not fix the issues on the plan, it could lose its tax-qualified status, and this could cost both the employer and the employee. The employer can fix the plan by making the maximum-allowed contribution to be lower, so the highest-paid employees can be on the same level as workers who are not fully active. The other method of fixing the plan is by recasting the excess contributions made by highly paid workers as taxable income.

In addition, it is a requirement for the employer contributions made to the plan to be fully vested. Moreover, the company must give their workers instant ownership, including workers who are fired during the year and those who willingly leave. Moreover, in this retirement plan, an employer must offer employer contribution to the employee’s account, and it can happen in any of the following ways:

Basic matching

The employer must match 100% of an employee’s contributions up to three percent of salary and 50% of contributions that are above 3% but less than 5%.

Non-elective contributions

The employer must deposit at least 3% of his or her employee’s compensation to the retirement plan, even if the employee does not contribute anything to their retirement account.

Enhanced matching

The employer should at least contribute something similar to what he or she would have made under the basic plan.

Both employers and employees can benefit from setting up and using retirement plans. For instance, businesses that offer retirement benefits attract highly qualified and skilled employees. They also give employees the option to contribute the amount they want to their own retirement plan accounts. Moreover, they benefit both employers and employees in different ranks and levels. 

Bottom line

The safe harbor retirement plan enables small business owners to accommodate the IRS nondiscrimination test. It also enables all employees to receive contributions from their employer to their retirement plan. Moreover, all employer contributions must be fully vested immediately after the employer makes them.