What Is a Safe Harbor 401(k)?

Definition and Examples of a Safe Harbor 401(k)

What Is a Safe Harbor 401(k)?

Theresa Chiechi / The Balance 

A safe harbor 401(k) is a type of retirement plan that helps small business owners accommodate the Internal Revenue Service (IRS) nondiscrimination test. It's a way to structure a plan that automatically passes the test or avoids it altogether.

The non-discrimination test requires that an employer must make contributions to each employee's plan equaling the same percentage of salary for everyone.

What Is Safe Harbor 401(k)?

The IRS regularly checks to make sure that highly-compensated employees or business owners aren't maxing out 401(k) plan contributions for the year while other 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 each retirement plan to determine that the average contributions of highly-compensated employees don't exceed the average contributions of everyone else by more than 2%. Businessowners can resort to safe harbor 401(k)s to avoid a higher percentage.

Highly-compensated employees are those who earned at least $125,000 in 2019 or $130,000 in 2020, or those who own more than a 5% stake in the business.

How Does a Safe Harbor 401(k) Work?

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 also a risk that your entire 401(k) savings would have to be refunded if the plan can't be fixed.

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.

A long vesting schedule isn't allowed with safe harbor plans. Contributions are fully vested when they're made. The company must give all employees ownership immediately, even those who leave or are fired during the year.

You can design your safe harbor 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 to 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.

How to Set up a Safe Harbor 401(k)

The 401k Help Center offers a list of retirement plan providers that will 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. Find someone 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. 

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 matching funds on a consistent basis.

A business can structure a plan to be age-based so the investors closest to retirement age 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.

Important 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. This is typically the end of the following year.

Key Takeaways

  • A safe harbor 401(k) plan is one that's set up to give employers some flexibility regarding IRS nondiscrimination rules for contributions.
  • This type of plan offers three options to ensure that the average contributions of highly-compensated employees don't exceed the average contributions of everyone else by more than 2%.
  • Employers must match employee contributions on a consistent basis.
  • Companies can amend their plans up until the 30th day before the plan year ends to take advantage of safe harbor provisions.

The Balance does not provide tax, investment, or financial services and advice. This information is 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.

Article Sources

  1. IRS. “401(k) Plan Fix-It Guide - 401(k) Plan - Overview.” Accessed Aug. 13, 2020.

  2. IRS. "Definitions." Accessed Aug. 14, 2020.

  3. IRS. ”401(k) Plan Fix-It Guide - The Plan Failed the 401(K) ADP and ACP Nondiscrimination Tests.” Accessed Aug. 13, 2020.

  4. Cornell Law School Legal Information Institute. ”26 CFR § 1.401(k)-3 - Safe Harbor Requirements.” Accessed Aug. 13, 2020.

  5. IRS. ”401(k) Resource Guide - Plan Participants - Summary Plan Description.” Accessed Aug. 15, 2020.

  6. House Committee on Ways & Means. "The Setting Every Community Up for Retirement Enhancement Act of 2019 (The SECURE Act)." Page 1. Accessed Aug. 13, 2020.