A Safe Harbor for Small Business Retirement Plans

I was out having a few beers on St. Patrick’s Day when I bumped into an old shipmate of mine from thirty years ago. Victor and I both went to Massachusetts Maritime Academy, where he was a mate and I an engineer. Ah, it was good to see Vic after so many years. Even after 30 years’ good shipmates just pick up where they left off. The beer was cold and the stories flowed. Vic and I were assigned to our first ship together which we joined in Valdez, Alaska where it got really interesting.

You see, our first ship together was not a text-book voyage. After hitting 40-60 foot stonewall swells wrapped around hurricane type winds, one of our needed auxiliary systems broke down. We hobbled into Portland, Oregon under the Safe Harbor Provision. This Provision is based on a concept that has been a part of the maritime tradition of the United States and most countries from around the world that allows a ship to safely seek refuge in time of danger.

Vic’s come a long way from our time at sea. He is happily married, three kids about my kids’ ages. Victor owns an office furniture rental company that he inherited from his parents. Victor loves what he does and is good at it. He and his twenty employees are doing well. In fact, Victor offers his employees a retirement savings plan in the form of a traditional 401(k) plan.

“My problem is getting employees to contribute to the plan as much as they should,” explained Victor. “As a result, it’s top-heavy. It cost the business a bundle last year to straighten out. What’s more, it cost me money too, because I was limited in what I could contribute to my own retirement!”

Vic was looking for a better retirement savings solution for himself, his business, and his employees. He was looking for a safe harbor.

And, at a time of record low unemployment, it’s good that Victor wanted to sweeten the pot. I explained to Vic that successful businesses need to stand out from the pack if they want to attract qualified, motivated employees. Offering a 401(k) plan sends a terrific message to prospective and existing employees: the company is invested in their future (both literally and figuratively) and is interested in fostering a long-term relationship.

As of September 2018, 401(k) plans held an estimated $5.6 trillion in assets – 19% of the $29.2 trillion in total US retirement assets, according to the Investment Company Institute. With so much of our wealth concentrated in 401(k) plans, you can see why the government tightly regulates such plans’ administration.

Unfortunately, this regulatory framework can create headaches for small employers with limited resources, like Victor. Only 53% of Small to Midsized Businesses (SMBs) offer retirement plans, according to a recent survey from The Pew Charitable Trusts. The study found that 37% of SMBs that didn’t provide a retirement plan cited cost as the issue, while 22% said they lack the organizational resources to manage one. For traditional 401(k) plans, that’s understandable, especially considering the annual process of nondiscrimination testing, which is where Victor’s business ran into trouble.

Nondiscrimination tests were designed to ensure that 401(k) plans don’t unfairly benefit highly compensated workers and business owners. The IRS defines Highly Compensated Employees (HCEs) as making $125,000 or more annually or owning more than 5% of the business’ interest in the past year, regardless of compensation.

These tests analyze the 401(k) plan’s Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP). Nondiscrimination tests help make sure that all eligible employees can fairly and equitably participate in the 401(k) plan if they so choose, regardless of where they are on the income scale. The top-heavy test, another test that is applied to 401(k) plans, compares the total balances of key employees such as owners (like Victor) and company officers with compensation of $180,000 or more, against the balances of regular (non-key) employees to make sure the plan isn’t top-heavy. If regulators find a discrepancy, it can cost the business money in fines, fees, and/or increased contributions – something Victor learned the hard way. And ultimately, if the employer fails to correct it in time, the plan itself may lose its tax-qualified status, according to the IRS.

A plan is considered top-heavy if the sum of all key employee balances exceeds 60% of its total. This is where Victor’s business had some problems. Because his employees hadn’t contributed to the plan the way he anticipated, the IRS required him to contribute and allocate more to even it out. Victor wasn’t interested in repeating the same mistake and needed a way to ensure it wouldn’t happen again.

I introduced Vic to a Safe Harbor 401(k) plan which can provide an appropriate alternative for businesses seeking to offer their employees retirement benefits while minimizing administrative cost, bureaucratic red tape, and potential liability.

Safe Harbor 401(k) plans provide a framework that fulfills the government’s nondiscrimination and top-heavy requirements, without the burden of testing, by providing a minimum level of contribution to the 401(k) plan for all staff.

The government offers different contribution formulas for businesses to use to comply with Safe Harbor provisions.

The basic matching formula requires that the business matches 100% of all employee contributions up to 3% of their compensation, plus a 50% match on the next 2%. An enhanced matching formula that is no less than the basis matching formula. And, a non-elective contribution formula, under which the business contributes at least 3% of each employee’s compensation, regardless of whether employees make contributions. It’s up to the company to determine what formula is right to use, depending on circumstances.

There are some very tangible benefits for employees who participate in a Safe Harbor plan. With a set employer matching contribution, employees who make salary deferral contributions see a ‘return’ on their retirement investment right from the start. Additionally, employees enrolled in Safe Harbor plans are immediately and fully vested. They also have the benefit of a pre-tax salary deduction, lowering their taxes for the year. The contribution limits on a Safe Harbor 401(k) are the same as other 401(k) plans: Up to the $19,000 maximum for 2019, and those who are age 50 and older can also contribute an additional $6,000 in catch-up contributions.

Safe Harbor plans have some benefits for employers, too. Besides regulatory compliance to bypass nondiscrimination testing, generally, Safe Harbor plans are also easier to administer and less expensive to manage than traditional 401(k) plans. Employer contributions to Safe Harbor plans remain tax-deductible, and employers can either make contributions to employee accounts throughout the year or in one lump sum deposit by their tax filing deadline, plus extensions. Safe Harbor plans also sport provisions for profit-sharing contributions, allowing for an aggregate contribution of up to $56,000 plus catch-up per employee – compensation allowing, so Victor can reward key employees without worrying about making the plan top-heavy again.

After reviewing his options over a few more beers, Victor elected to add Safe Harbor provisions to his company’s existing 401(k) plan. He will utilize the enhanced matching formula with a 4% contribution and predicts it will be easier to understand and more appealing for his employees. This approach should see an uptick in employee enrollments and contributions helping to put Victor and his company in a better position of financial success.

Victor’s being vigilant and staying alert because he and his employees deserve more.

Have a great week!

Jeff Cutter, CPA/PFS is President of Cutter Financial Group, LLC, a wealth management firm with offices in Falmouth, Duxbury, and Mansfield. Jeff can be reached at jeff@cutterfinancialgroup.com.

Cutter Financial Group LLC (“Cutter Financial”) is a SEC Registered Investment Advisor.

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