Safe Harbor vs Traditional 401(k): Are you currently offering the optimal retirement plan?

Nov 30th, 2020: The deadline to add the Safe Harbor provision to an existing plan for 2021.

Traditional 401(k) plans can be established by the employer and do not require an employer contribution match. Each active participant chooses the payroll deduction amount and investment selections that best suit their goals. For 2020, the IRS contribution limits are $19,500, and for those that are 50 years old and older, there is an additional $6,500 catch-up provision. 

The caveat to consider when offering a traditional 401(k) plan, is that there is annual testing, according to the IRS 401(k) Plan Overview, that needs to occur by the plan administrator to ensure that the proportion of 401(k) savings between highly and non-highly compensated employees is in balance (the cutoff is $130,000 in gross salary). If the 401(k) plan fails one of these tests, a portion of the 401(k) contributions from the highly compensated employees is returned to the employees as a mandatory distribution. That returned amount is a taxable event for that person. The individual is not able to save as much in the 401(k) plan as they had wanted and may face higher taxable income.

Safe Harbor 401(k) plans are an alternative to a traditional 401(k) plan. There are 3 matching options from which you can choose in order to get all the benefits of a Safe Harbor 401(k) plan. By providing the employer match, the 401(k) plan bypasses annual testing as described in the traditional 401(k) plan. Bypassing the annual testing avoids mandatory corrective distributions for the highly compensated employees. This can help lower all employees’ taxable income and save on many employer resources, including time and effort, which often correlates to cost savings. Employer contributions are tax-deductible on the employer’s federal income tax return.