Drowning on the Shores of a Safe Harbor?
Posted by Andrea Vassiliadis on Fri, Jan 15, 2010 @ 10:26 AM
It never ceases to amaze me how often I meet with a prospective client that has an existing 401(k) plan, and they have no idea why their plan is designed the way it is. Last week, I met with a client who was not happy that they were locked into making a 3% Safe Harbor contribution to their employees, as cash flow was very tight. There was nothing I could do for them for 2009, but I certainly want to help them review their options for 2010.
Having a Safe Harbor provision can be a silver bullet in these plans, to eliminate a couple of key testing issues. The most common reason is to avoid the "Average Deferral Percentage" or ADP test. In simplified terms, this test is failed when the ADP test of "Highly Compensated Employees" (HCEs), defined as over 5% owners, and/or those earning over $110K in the prior year, EXCEEDS the ADP test of the "Non Highly Compensated Employees" (NHCEs), by more than two percent. If that happens then generally the HCEs have to be refunded some of their deferrals, which then becomes taxable income again.
A Safe Harbor provision eliminates this test, and commits the company to making EITHER:
- a 3% of eligible pay contribution (regardless of whether the employee is deferring on their own)
- or a matching contribution
Either way it must be 100% vested immediately, UNLESS (remember my last blog? "Auto Enroll vs. Employees Doing Nothing") the company has chosen to auto enroll participants. In which case the company can have up to a two year vesting schedule on the Safe Harbor. They must notify employees by December 1 of the prior year that they will be doing this the following year, and are basically locked in. The company can terminate this mid-year, but it's a messy process.
I gathered up this client's prior reports and census information to take a closer look. Their plan was with a payroll company which performed this ADP test every quarter, even though it was unnecessary in place. The quarterly testing was unnecessary because the plan had a Safe Harbor. What leaped out at me was the fact that the test passed with flying colors for the last three years (since the inception of the plan)! There was one HCE (the owner), who was not even participating! When I asked why, I was told he never intended to participate, and he considered his retirement investments to be his company and some real estate ventures. His goal for even offering a plan was to be competitive in the market place for recruiting purposes. So the burning question was: Why were they set up with a Safe Harbor provision in the first place? The client couldn't tell me, didn't even remember a discussion about it, and were quite upset when they finally understood what a Safe Harbor is and the purpose for having it in place.
Too often plans are designed with these "vanilla" provisions, obligating the company to terms they do not understand, do not necessarily need, and might not be able to afford in this economy. I'm starting to see a trend in my blogs as I ruminate on this stuff: an expert should be reviewing, consulting, and designing these plans to meet the specific goals of the client!