Retirement Plan Options

Al Martin, Esq.

As you know, a 401(k) plan permits employees to elect to contribute (an “elective deferral”) a portion of their compensation to the employer’s retirement plan rather than receiving the compensation. Deferring compensation to the plan postpones state and federal income tax on the deferrals and also permits the deferrals to grow on a pre-tax basis in the plan. Like all qualified retirement plans, 401(k) plans cannot discriminate in favor of highly compensated employees. In order to prove that it is not discriminatory, a 401(k) plan must pass the Actual Deferral Percentage (ADP) test with respect to employee deferrals and the Actual Contribution Percentage (ACP) test with respect to any employer matching contributions.

The benefit of the safe harbor 401(k) plan is that the employer does not need to perform the tricky “ADP” and “ACP” tests on an annual basis. In addition, the employer does not need to make an extra contribution or return some of the deferrals of highly compensated employees (so called “HCEs”), which has to be done if a regular 401(k) plan fails these tests. Consequently, any highly compensated employees (“HCEs”), subject to certain limitations, may contribute the full 401(k) plan annual dollar amount ($11,000 for calendar year 2002), without regard to the amount any nonhighly compensated employee defers.

As in all 401(k) plans, the annual employer deduction limit, effective as of January 1, 2002, is 25% of eligible participants’ compensation, and each participant is limited to total employer and employee contributions to all plans of 100% of compensation or $40,000 (plus any catch up contribution for those age 50 or more), whichever is less. For ERISA purposes, compensation is limited to $200,000 for plan years beginning in 2002.

Two Alternative Employer Contribution Options

The “cost” of this automatic compliance with the ADP and ACP tests is the employer must provide a minimum contribution which is either a (1) 100% vested, nonelective employer contribution of 3% of pay for all participants, including the highly paid, or (2) a 100% vested employer matching contribution.

i) The 3% Employer Contribution. The required nonelective contribution is a 3% employer contribution for each employee eligible to make deferrals, regardless of whether they are employed on the last day of the plan year or have 1,000 hours of service. The 3%-of-pay Safe Harbor option can be satisfied by providing an employer contribution on behalf of all eligible nonhighly compensated participants equal to at least 3%-of-pay regardless of whether or not they make deferrals into the 401(k) plan.
In addition to satisfying the contribution requirement, this 3%-of-pay contribution will satisfy the minimum contribution requirements in top-heavy plans. It can also be used as part of a “new comparability” contribution formula (including the 1/3, 5% and 7.5% thresholds, if applicable), which are usually designed to maximize contributions for executives, long term employees, or employees who are critically important. It cannot, however, be used for purposes of Social Security integration (“permitted disparity”).

Additional employer discretionary profit sharing contributions with a vesting schedule can also be made.
Fixed Match with 3% Safe Harbor. A fixed match of a lesser amount can be used if the 3% safe harbor is used. For example, a plan that uses the 3% safe harbor may also match a percent of employee’s contributions they each make up to deferrals of 6% of their pay. See Notice 98-52, section VI, D, Example 3.

Additional Discretionary Match. Additional employer discretionary matching contributions can also be made, under a uniform formula, for example, but not in excess of 4% of pay (for example, of 1% for each 1% of employee deferrals limited to deferrals of 6% is permissible) . These discretionary matching contributions cannot be counted toward the fixed match above. See Notice 98-52, section VI, B, 4, b and the last sentence of VI, B, 4, a.
ii) Employer Match Safe Harbor. The employer matching contribution, if used, may take several forms. Where the safe harbor match is used, and no 3% safe harbor is used under item 1 above, a plan must provide a matching contribution of up to at least 4% of an employee’s compensation. The basic required match is dollar for dollar on the employee deferrals up to 3% of pay and 50¢ per dollar on the next 2% of pay. Thus, an employee must defer 5% of pay to get this minimum safe harbor 4% employer matching contribution. Where this employer matching safe harbor is used, an employee who defers nothing gets no employer matching contribution (nor any employer nonelective 3% contribution where the matching safe harbor is used in lieu of the 3% nonelective safe harbor).

Other acceptable required matching formulas are (1) a plan that matches 100% of an employees elective deferrals up to 4% of the employee’s compensation (here the employee receives a match by deferring only 4% of pay instead of 5% of pay, as in the required basic matching formula), (2) a plan that matches 125% of employee elective deferrals up to the first 3% of employee deferrals and then matches 25% of elective deferrals between 3 and 4% of compensation, with no additional match thereafter. Here again, if the employee defers 4% or more of his or her pay, the employee receives a 4% match.

To use any alternative enhanced matching formulas, the employer must meet the following three criteria: (a) the total rate of match at each and every level of elective contributions must be at least as high as that under the basic matching formula (Notice 98-52); (b) the matching rate cannot increase with increases in the rate of elective contributions and (c) the rate of match for any HCE cannot exceed the rate of match for any NHCE at the same percentage level of elective contribution. See IRC §401(k)(12)(B)(iii)(m)(11)(i).

Neither an employment on the last day of the plan year nor 1,000 hours of service test condition can be used as a condition a safe harbor match for an employee who has met the plan’s eligibility tests (which can require being age 21 and a “year of service” in which 1,000 hours of service are required).

Compensation can be defined to include the entire plan year (the normal approach) or only from participant’s entry into the plan; the use of the entire year, however, reduces the match percentage and therefore reduces the employer’s contribution. See Notice 98-52, section IV, B.

If the employer makes safe harbor matching contributions, the following additional requirements apply:

· Match Rate. The rate of matching contribution for any highly compensated employee cannot exceed the rate for any nonhighly compensated employee making the same level of employee deferrals. This makes it unlikely that a service-weighted matching formula will qualify for the Safe Harbor.

· Basic Required Fixed Match. The rate of employer matching contribution cannot increase as the rate of employee deferral increases. This requirement will automatically be met if the employer makes the Safe Harbor matching contribution of 1% by the employer for each 1% of employee deferral contribution, up to 3%, and a 50% employer contribution on employee deferral contributions of more than 3% of pay and not more than 5% of pay. Thus, the maximum employer match is 4% for an employee who defers 5% or more of his/her pay. No greater match is required by the safe harbor for an employee who defers more than 5% of his/her compensation, although it is permitted.

Other enhanced required matching formulas are permitted, as discussed on the preceding page.

· Employee Deferral Limit. While employee elective deferrals can exceed 6% of pay, no required fixed employer match (regardless of the formula) may be made on employee deferral contributions of more than 6% of the participant’s compensation. The match itself can be more than dollar for dollar, such as $2.00 for each $1.00 of deferral, but deferrals above 6% of pay are disregarded. (A match of $2.00 for each $1.00, where the employee defers $8,000, which is 8% of pay, can be made in the amount of $12,000 ($2.00 x $6,000). See Notice 98-52, section V, B, 2 and 3.
· Additional 401(k) Safe Harbor Match Rules. Under Notice 2000-3, the IRS clarified certain important features of the matching safe harbor 401(k) plans:
(1) An employer can terminate the employer matching feature upon 30 days notice to participants at any time during the year. That year the plan will then need to be tested under the regular ADP/ACP tests.

(2) If an employer matches at least quarterly, the employer does not again need to re-test the matching contributions based upon the entire year’s results. The formula, if applied on a quarterly or more frequent basis, will often yield different results than if the match occurs after the plan year is over due to (1) changes in employee compensation, (2) employee changes in their deferral percentage, or (3) termination of employment mid-year. If the plan matches on a payroll-by-payroll, monthly, or plan quarter basis, the matching contributions required for the last day of a plan quarter must be made by the last day of the following plan quarter. Thus, for example, in a calendar year plan, matching contributions for the third quarter beginning July 1, 2001, must be made by December 31. See IRS Notice 2000-3 Q&A 2.

(3) Employee deferrals can be required to be in whole dollar amounts or whole percentage amounts.

(4) If participants are included who have not met the required minimum age and service normally required by the plan, they can be treated separately and need not receive the safe harbor contribution.

Top Heavy Rules and Exemptions

In 2002 and thereafter, the top heavy rules do not apply at all to safe harbor 401(k) plans consisting solely of 401(k) safe harbor deferrals and either the 3% employer safe harbor contribution or the 401(m) safe harbor matching contributions. Any regular employer profit sharing contributions to a safe harbor 401(k) plan, however, remain subject to the top heavy rules.

In 401(k) plans subject to the top heavy rules, matching contributions will count toward satisfying the top heavy minimum contribution limit and are still counted in the ACP nondiscrimination test. So if the plan has employer profit sharing contributions and is top heavy, and if there is an employer match that equals 3% of pay (or more) for 401(k) participants, the employer would not have to put in additional money for those 401(k) participants receiving at least a 3% match due to the top heavy rules, but would have to put in 3% of pay for other non-key employee-participants.

Compensation, Vesting and Other Safe Harbor Requirements
As provided under §1.401(k) 1(g)(2), an employer may limit the period used to determine compensation for a plan year to that portion of the plan year in which the employee is an eligible employee, provided that this limit is applied uniformly to all eligible employees under the plan for the plan year. As stated above, either type of safe harbor contribution must be 100% vested. It also may not be subject to an hour of service requirement or a last day of the plan year employment requirement. However, the plan (1) can require an age 21 and “year of service” (at least 1,000 hours of pay in a 12 month period) for an employee to be eligible to be in the plan and these contributions, and (2) may also provide additional employer profit sharing contributions, which may be subject to a vesting schedule and subject to these 1,000 hour and employment on the last day of the year “accrual” requirements. Finally, the plan may not allow for distributions of the employer’s safe harbor contributions during employment, below age 59½, except in the event of separation from service, death, or disability. While employee deferral contributions can be withdrawn for hardship if the plan so provides, no hardship withdrawals are allowed for employer safe harbor contributions. See Notice 98-52.

While the 3% safe harbor contribution can be provided in another plan, such as a money purchase plan, ESOP, etc., it must be subject to all of these tests. Thus, there can be no last day of the plan year allocation condition, no 1,000 hour test, and the 401(k) withdrawal restrictions must apply to that plan.

Notice Requirements

Notices for new plans, as well as required annual notices for existing plans, must be given within a reasonable time. Notices given under the guidelines below are presumed to be reasonable. In general, an employer must provide a notice to employees either (1) at least 30-90 days prior to the beginning of each plan year, or (2) at least 30 days before the end of the plan year, if the employees also received a notice before the beginning of the plan year that the employer might utilize a safe harbor plan during that plan year. The annual notice rules are as follows:

Existing Plans – Generally required 30-90 days before first day of each plan year (Notices 98-52 and 2000-3). However, the notice to a new participant may be given as late as the first day of plan participation and not sooner than 90 days before plan eligibility.

New Plans – Employers may give written notice up to effective date of plan (Notices 98-52 and 2000-3), unless it is a “successor plan”, as discussed below. Notice 98-52, item X deals with plan years of fewer than 12 months. It states: “A plan will fail to satisfy the ADP test safe harbor or the ACP test safe harbor for a plan year unless (i) the plan year is 12 months long or (ii) in the case of the first plan year of a newly established plan (other than a successor plan), the plan year is at least 3 months long (or, any shorter period in the case of a newly established employer that establishes the plan as soon as administratively feasible after the employer comes into existence).” Where it is after October 1 and the employer is not a new company, a 5% HCE contribution rate may be used for the first year of a 401(k) plan based upon an 3% assumed NHCE prior year testing methodology. Accordingly, if the 3 month rule cannot be satisfied to implement a 401(k) safe harbor, (for example, if the plan is established on November 1, 2002), a non safe harbor 401(k) plan may be established using a calendar year end which permits the HCEs to defer 5% of 2001 salary. Thus, for an HCE earning more than $200,000 for 2002, the employee may defer $10,000. The safe harbor provisions would be effective 2003, assuming the proper notifications are given.

Addition of 401(k) arrangement to existing non-401(k) plan – treated as new plan (Q&A-11 of Notice 2000-3). As is the case with the establishment of a new plan, a safe harbor 401(k) arrangement may not be added to an existing non-401(k) plan unless the 401(k) arrangement will be in effect for at least 3 months of the plan year. See the discussion below about the amendment of an existing profit sharing plan to add safe harbor provisions.

Successor Plans. A plan may not use the “new plan” rule if the plan is a “successor plan,” as that term is used in Notice 98-1. Under Notice 98-1, a successor plan is a 401(k) plan in which at least 50% of the eligible employees were eligible for another 401(k) plan maintained by the employer in the prior year. However, a SEP-IRA or Simple IRA is not a plan for this “successor plan” rule, so a safe harbor 401(k) plan that replaces either type of IRA plan is nevertheless a new plan. See Regs. 1.401(k)-1(g)(11), 1.410(b)-7, 1.414(l) and I.R.C. §411.

Electronic Notices. Q&A-7 of Notice 2000-3 allows electronic notices.

Finally, any employee who becomes eligible after notice period must receive notice by date of eligibility (Notices 98-52 and 2000-3).

Amendment of an Existing Profit Sharing Plan to Add Safe Harbor Provisions

Notice 2000-3 provides that the addition of a 401(k) arrangement to a non-401(k) plan is treated as a new plan for purposes of the safe harbor 401(k) rules. Thus, the employer may add the arrangement after the first day of the plan year, and the notice requirements can be satisfied as of the first day that the 401(k) arrangement is in effect. As is the case with the establishment of a new plan, a safe harbor 401(k) arrangement may not be added to an existing non-401(k) plan unless the 401(k) arrangement will be in effect for at least three months. For example, suppose an employer maintains a calendar-year profit sharing plan. That employer may add a safe harbor 401(k) arrangement as late as October 1, 2002, so long as the safe harbor requirements are met from the effective date of the 401(k) arrangement to the end of that first year. The safe harbor notice would have to be given to employees no later than the effective date of the 401(k) arrangement, that is, October 1 in this example.


If an employer with a regular non-safe harbor 401(k) plan wants to wait to decide to provide the 3% nonelective contribution, a decision can be made as late as 30 days before the last day of the plan year whether to make the contribution. If the contribution is not to made, nothing needs to occur. But the plan must be amended so as to provide for the 3% contribution if the employer decides to use that option, and such amendment could be limited for just that plan year in question, leaving open the option for the next year if the requisite notice is given before the next year begins. The notice must be given to employees before the beginning of the plan year in which the 3% safe harbor might be used that would simply indicate that the employer might or might not decide to make the nonelective contribution. If the employer later decides to do so, a supplemental notice would be given (no later than 30 days before the end of the plan year, and the plan would be amended to allow it, which could be limited just to that year. .

Second, if the employer wants to do the safe harbor matching contribution instead of the nonelective contribution, the employees would have to be notified of that decision during the normal notice period (i.e., 30-90 days before the first day of the plan year), but the employer later could decide to discontinue the match during the plan year (with prior notice to employees) and opt to run ADP/ACP testing that year. The discontinuance of the match could take effect sooner than 30 days after notice of such discontinuance is given to the employees.

Termination of Safe Harbor Plan

If the requisite employee notices have been given for a safe harbor 401(k) plan, and if the participants made elective contributions in reliance on a promised employer match, both ERISA Title I Title II would likely be interpreted to require the employer to make the contribution through a date of termination of which the participants are notified. Terminating a safe harbor plan mid year should be permitted because once the plan termination is made and announced to employees, no further elective deferrals can be made. The participants should receive the employer contributions that they were promised through the date of termination.

Please contact us if you have any questions regarding the safe harbor 401(k) plan or want to discuss the use of the safe harbor 401(k) plan option.

Al Martin, Esq.
Shook, Hardy & Bacon, LLP
Overland Park, Kansas