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Safe Harbor FAQ: What Employers Should Know About 401(k) Compliance Testing

Employee Benefits

Any company that offers a 401(k) or 403(b) retirement plan should be aware of the government compliance tests that plans must undergo to ensure they do not discriminate in favor of highly compensated employees or key employees. Employers should also be aware of safe harbor plan design options, which may help them avoid annual nondiscrimination testing. Take a look at some safe harbor questions we hear most from business owners.

What does "safe harbor" mean?

Generally speaking, a safe harbor is a provision in the law that says certain conduct will be considered as not in violation of a rule or requirement. In relation to 401(k) plans, it refers to a method by which employers can avoid being subject to nondiscrimination testing rules set by the federal government.

What are nondiscrimination tests?

The federal government wants all employees to participate in and benefit from employer-sponsored retirement plans — not just the highest paid employees. Therefore, plan sponsors must undergo annual nondiscrimination testing that compares the actual deferral percentage (ADP) and the actual contribution percentage (ACP) made by highly compensated employees to their retirement accounts to those made by rank-and-file employees. In 2017, highly compensated employees are those earning above $120,000 or those who own at least 5 percent of the company, regardless of their compensation.

In order to pass nondiscrimination testing, the ADP and ACP of highly compensated employees must not greatly exceed the ADP and ACP of non-highly compensated employees.

The top-heavy test, another annual nondiscrimination test, looks at what percentage of the plan's present value belong to "key employees," requiring that no more than 60 percent of assets belong to those employees. A key employee is somewhat different than a highly compensated employee, but they are similar in that they have higher-than-average income.

What happens if a plan fails?

If an employer fails the nondiscrimination test, there are two corrective options available. The first option is to refund some of the contributions made by the highly compensated employees through what's called corrective distributions. Those refunded amounts would then become taxable to those employees. The company would also face a 10-percent excise tax if they do not make refunds by the annual deadline. The second option is to fund a Qualified Non-Elective Contribution (QNEC) to the non-highly compensated employees to the extent needed to pass the test.

Small businesses are especially prone to failing because owners often want to contribute a large sum of their income to the tax-deferred retirement plan and they may not have enough non-highly compensated employees making contributions to meet the nondiscrimination requirements.

How common is it to fail?

One analysis in 2014 found that nearly 60,000 401(k) plans failed their most recent nondiscrimination tests, leading to $794 million in retirement plan contributions being refunded to highly compensated employees and becoming taxable.

What is a safe harbor plan design?

Employer-sponsored retirement plans can avoid annual nondiscrimination testing by instituting a so-called safe harbor plan design. This can happen one of two ways:

  • A plan sponsor can provide a 100 percent match to pre-tax contributions made by non-highly compensated employees on 3 percent of their pay, plus a 50 percent match on the next 2 percent of pay.
  • A plan sponsor can automatically contribute 3 percent of pay to the retirement accounts of all non-highly compensated employees, regardless of whether those employees contribute to their accounts.

Deciding which safe harbor design option makes the most sense can depend on the employer and how much incentive they want to give employees to contribute to their own retirement accounts.

Is safe harbor plan design the only way to avoid nondiscrimination rules?

No, but it's the easiest. Encouraging all employees to participate in and contribute to their retirement plan can increase the odds that a plan will pass nondiscrimination testing. One way to achieve this is through automatic contributions, which means employee contributions are automatically deducted from their paycheck unless they opt out. The more that non-highly compensated employees contribute to the plan, the less of a problem it will be for highly compensated employees who want to contribute more.

Employers need to be aware of nondiscrimination rules and may want to consider using a safe harbor plan design to reduce the risk of failing the annual compliance tests.


This website contains articles posted for informational and educational value. Paychex is not responsible for information contained within any of these materials. Any opinions expressed within materials are not necessarily the opinion of, or supported by, Paychex. The information in these materials should not be considered legal or accounting advice, and it should not substitute for legal, accounting, and other professional advice where the facts and circumstances warrant.
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