How Business Owners Can Max Out 401k Contributions

Peter A. ScilovatiOctober 13, 2016

Wealth Preservation & Distribution

While recently helping a small business owner decide whether to install a 401k plan for her company, the question came up about the safe harbor provision of a retirement plan – She asked: “What is that and how does it benefit the employer”?

Some background information: 401(k) plan sponsors must test traditional 401(k) plans each year to ensure that the contributions made by and for rank-and-file, non-highly compensated employees (NHCE) are proportional to contributions made for owners and managers or highly compensated employees (HCE). As the non-highly compensated employees save more for retirement, the rules allow highly compensated employees to defer more. These nondiscrimination tests for 401(k) plans are called the ADP (Actual Deferral Percentage) and ACP (Actual Contribution Percentage) tests.

An important aspect of performing the ADP and ACP tests is to properly identify the HCEs, who are generally any employee who:

  • Was a 5% owner at any time during the current or prior year (a 5% owner is someone who owns more than 5% of the employer’s company), or
  • For the prior year, was paid by the employer more than $115,000 for 2014 and $120,000 for 2015; subject to cost of living adjustments in later years and, if the employer elects, was in the top-paid (top 20%) group of employees.

(Family aggregation rules treat a spouse, child, grandparent or parent of someone who’s a 5% owner, as a 5% owner. Each of these individuals is an HCE for the plan year.)

Under a safe harbor 401(k) plan, the employer isn’t required to perform the ADP and ACP tests, if it meets certain requirements. “Safe harbor” 401k plans are the most popular type of 401k used by small businesses today. They allow business owners to maximize contributions to the plan. To achieve safe harbor status, owners are required to make either an eligible matching or non-elective contribution to participants:

  • Safe harbor matching contribution – 2 options are available:
    • Basic match – 100% match on the first 3% of deferred compensation plus a 50% match on deferrals between 3% and 5% (4% total).
    • Enhanced match – Must be at least as much as the basic match at each tier of the match formula. A common formula is 100% match on the first 4% of deferred compensation.
  • Safe harbor non-elective contribution – 3% (or more) of compensation, regardless of 401k deferrals. For example, an employee who contributes 0% from their compensation would still receive the 3% employer contribution.

These contributions can be limited to just non-Highly-Compensated Employees (HCEs) and they must be 100% immediately vested.

Alternatively, discretionary matching contribution from the employer is exempt from the ACP test just as a safe harbor match when two conditions are satisfied:

  • The match formula cannot be based on more than 6% of deferred compensation.
  • The match cannot exceed 4% of compensation in total.

For example, a discretionary 50% match on the first 6% of deferred compensation (3% total) would be exempt from the ACP test.

For many employers, that trade-off is well worth the cost. Here’s why. When 401k testing fails, it’s usually business owners that bear the burden of the consequences. And —  small businesses tend to fail more because business owners generally have a larger percentage of plan assets. They often receive the largest 401k refunds when the ADP/ACP test fails.

Given these consequences, it’s no surprise business owners find safe harbor 401k plans attractive. They allow business owners to maximize their 401k contributions without the risk of refunds.

Safe harbor 401k plans can be a great choice for small businesses that have trouble passing 401k testing. However, they are not for everybody – they can be more expensive than traditional 401k plans. We advise small business owners to weigh the pros and cons of these plan before choosing one for their company.



Employee Fiduciary Corp. , Mobile, AL.