What Is a Safe Harbor 401(k)?

Small business owners who want to save a ton have a Safe Harbor 401(k) option

Image by Theresa Chiechi © The Balance 2019 

A safe harbor 401(k) is a type of 401(k) retirement plan that allows small business owners to skirt a specific Internal Revenue Service (IRS) test. It's a way to structure a plan that automatically passes the nondiscrimination test or avoids it altogether. An employer must make contributions to each employee's plan equaling the same percentage of salary for everyone.

For example, the company might add another 5% of their salary for every contribution made by an employee. The amount matched depends on the contributions of the business owner. 

Rules for Safe Harbor 401(k)s

A long vesting schedule isn't allowed with safe harbor plans. Contributions are fully vested when they're made. This means that the company must give all employees their share—even those who leave or are fired during the year.

You can design your plan to limit matching contributions to only those employees who defer compensation, or you can make contributions for everyone, including those who don't contribute to their own plans.

Plans can allocate contributions in one of three ways: 

  1. Basic: The employer matches 100% of the first 3% of compensation, plus 50% of the next 2% of compensation.
  2. Enhanced: The employer matches 100% on the first 4% of compensation.
  3. Non-Elective: The employer contributes 3% of compensation to all eligible employees.

A safe harbor provision can be attached to any type of retirement plan or 401(k), but it requires a lot of written notification and education for plan participants. They must receive these documents within 30 to 90 days of beginning employment. But it should be easy enough to execute after you get a plan set up.

The Problem Safe Harbor 401(k)s are Designed to Solve 

Most 401(k) plans face an annual nondiscrimination test. The IRS checks to see if a highly compensated employee or business owner is maxing out 401(k) contributions for the year while the remaining employees lag in their savings.

The IRS wants to see that all employees are taking advantage of the retirement plan, not just those with high-paying jobs. It tests the plan to determine that the average contributions of highly-compensated employees don't exceed the average contributions of everyone else by more than 2%.

Highly-compensated employees are those who earned at least $125,000 in 2019, or those who own more than a 5% stake in the business.

It might raise a flag for the IRS if you're a business owner and your 401(k) has low adoption rates or saving rates among rank-and-file employees. According to the Plan Sponsor Council of America, a lobbying business for the retirement planning industry, most businesses pass the test but around 40% claim to have reported refunding or restricting plan contributions to do so. 

The IRS can reject a retirement plan contribution if it feels it's excessive. You or your employee would then owe federal and state income tax on the money. There could also be a 10% penalty fee on the excess contribution. There's a risk that your entire 401(k) savings would have to be refunded if the plan can't be fixed through refunded contributions.

Some Changes in 2020

The Setting Every Community Up for Retirement Enhancement (SECURE) Act increased the limit for automatic increases in an employee's deferrals from 10% to 15% when it was signed into law in December 2019.

The SECURE Act also provides that companies can amend their plans up until the 30th day before the plan year ends. Amendments after that time can still be allowed if they increase nonelective contributions by at least 4% for all eligible employees. The previous threshold was 3%.

The plan must be amended by the last day for paying out excess distributions for the plan year, however. This is typically the end of the following year.

Setting Up a Safe Harbor 401(k) 

The 401k Help Center offers a list of retirement plan providers to help you find a 401(k) or customized retirement plan for your small business. You can also ask fellow business owners or financial professionals in your area for recommendations.

"Plan factories" are not necessarily better than knowledgeable experts who live in your area. It can pay to shop around when you're looking for a safe harbor.

Safe Harbor 401(k) plans tend to be more suitable for companies with predictable revenue streams. Other 401(k) plans might be better alternatives if you think your business could have difficulty finding matching funds on a consistent basis.

A business can structure a plan to be age-based so the investors closest to retirement can receive more in employer contributions. There are also comparability plans that break the employees into classes or tiers, with older or key employees given a larger profit share.

Find someone to advise you who understands the various options and who can explain them to you and find a way to maximize contribution limits for you and other key employees. 

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor, and it might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.

Article Sources

  1. IRS. “401(k) Plan Fix-It Guide - 401(k) Plan - Overview.” Accessed March 4, 2020.

  2. Legal Information Institute. ”26 CFR § 1.401(k)-3 - Safe Harbor Requirements.” Accessed March 4, 2020.

  3. IRS. ”401(k) Resource Guide - Plan Participants - Summary Plan Description.” Accessed March 4, 2020.

  4. IRS. ”401(k) Plan Fix-It Guide - The Plan Failed the 401(K) ADP and ACP Nondiscrimination Tests.” Accessed March 4, 2020.

  5. House Committee on Ways & Means. "The Setting Every Community Up for Retirement Enhancement Act of 2019 (The SECURE Act)." Page 1. Accessed March 4, 2020.