In business, it’s important to consider fairness when dealing with plans and perks as they relate to employees. For retirement plans specifically, the IRS ensures fairness by administering nondiscrimination compliance tests each year. The tests can be time-consuming and arduous; and employers most certainly do not want to fail these measures and risk heavy fines.
Thankfully, a solution exists to ensure that you can move past these tests each year without any concern: The Safe Harbor 401k.
What Do the IRS Nondiscrimination Tests Look for?
There are three tests administered by the government each year to verify that lower income workers aren’t being discriminated against in favor of other, higher income employees and 401k contributors within a given company.
The tests are as follows:
- The ADP Test (Actual Deferral Percentage). The ADP test is perhaps the most applicable one of the tests as they relate to small businesses. This test confirms that the percentage of income “higher income earners” defer to their plans is appropriate when compared to lower-wage employees.
- The ACP Test (Actual Contribution Percentage). This is a test that checks to make sure that the matched contributions by the employer are not unfairly high as compared to that of lower-wage employees.
- The Top Heavy Test. The Top Test verifies that the business owner and other key employees do not make up greater than 59% of the total plan balance.
Failing these tests can create a nightmare for business owners. A failure results in masses of paperwork, fines, corrections, and late penalties if the corrections aren’t made swiftly. While the IRS does provide guidance on how to correct the issues that caused you to fail the test, it is always ideal if you plan ahead and are certain that you will pass the tests.
How Does a Safe Harbor 401k Plan Help in Terms of IRS Nondiscrimination Testing?
Having a Safe Harbor 401k plan in place guarantees that you will pass these tests without any extra effort. Essentially, the plan works by allowing businesses to pass the IRS tests hassle-free each year in exchange for business owners contributing a minimum amount to the plan every year.
These contributions can be made in one of three ways:
- Basic Matching Method. With basic matching, the employer matches every individual employee’s contribution 100%. This method also stipulates that the matching can be up to 3% of the employee’s annual contribution.
- Enhanced Matching Method. With enhanced matching, the employer matches each employee’s contribution 100% or more. Further defined is that the matching can be up to 4% of all employee’s compensation.
- Non-Elective Contribution Method. Without regard to employees’ contribution amounts, the employer matches at least 3% of every employee’s income.
Is it too Late to Set-up a Safe Harbor 401k for 2021?
If you are starting a new plan in 2021, you must complete the process by October 1st, 2021. However, if you want to modify your existing plan to include a Safe Harbor Provision, the deadline is November 30th 2021.