Safe Harbor or Traditional 401(k) Plan – How to Decide

Safe harbor 401(k) plans are the most popular type of 401(k) used by small businesses today. Unlike a traditional 401(k) plan, they automatically pass the ADP/ACP and top heavy nondiscrimination tests when certain employer contribution and participant disclosure requirements are met.  This trade-off is well worth the cost for many business owners, who often bear the brunt of the consequences when their 401(k) plan fails testing.  

However, a safe harbor 401(k) plan is not the best fit for every small business.  In general, a traditional 401(k) plan offers greater plan design flexibility – which can make it easier for business owners to meet plan goals for the lowest possible cost.

If you’re a business owner, you want to know when a safe harbor or traditional 401(k) plan is best for your company.  Both 401(k) types require trade-offs. To make an informed decision, you must know two things:

  1. Whether your 401(k) plan can pass the ADP/ACP or top heavy nondiscrimination tests
  2. How safe harbor status will limit the flexibility of your 401(k) plan design.

The ADP/ACP Test

The Actual Deferral Percentage (ADP) test compares the salary deferrals (both pre-tax and Roth) made by Highly-Compensated Employees (HCEs) to the salary deferrals made by non-HCEs to ensure that HCEs don’t disproportionally benefit. The Actual Contribution Percentage (ACP) test applies to matching and voluntary contributions instead of salary deferrals.

For 2021, an HCE is defined as an individual who meets one of the following two criteria: 

  • They own more than 5% of the employer (directly or by family attribution) at any time during 2021 or 2020
  • They received compensation in excess of $130,000 during 2020. A plan can limit this group to the top 20% of employees, ranked by compensation

The ADP test is passed when the average deferral rate of eligible HCEs doesn't exceed the greater of:

  • 125% of the non-HCE average, or
  • the lesser of:
    • 200% non-HCE average, or
    • the non-NHCE average plus 2%.

The ACP test uses the same methodology to test matching and voluntary contributions. 

The non-HCE average can be based on current or prior year contributions – as specified by the plan document. 

If the ADP and/or ACP test fails, the most common correction method is distributing excess (discriminatory) contributions to HCEs in the amount necessary to make the applicable test pass. Over time, these test refunds can dramatically handicap the growth of HCE accounts due to the power of compound interest.

The Top Heavy Test

A 401(k) plan is considered top heavy for a plan year when the account balances of Key Employees exceeded 60% of total plan assets on the last day of the prior plan year (e.g., December 31, 2020 for a calendar 2021 plan year). 

A Key Employee is defined as any employee (including former or deceased employees), who at any time during the plan year was:

  • An officer making over $185,000 (2021)
  • A 5% owner of the business (a 5% owner is someone who owns more than 5% of the business)
  • An employee owning more than 1% of the business and making over $150,000 for the plan year

When a 401(k) plan is top heavy, non-Key Employees must generally receive an employer contribution equal to 3% of their annual compensation. Any employer contribution (matching or profit sharing) can be used to offset the top heavy minimum contribution. 

The Differences Between Safe Harbor and Traditional 401(k) Plans

When choosing between a safe harbor and traditional 401(k) plan, you should understand their plan design options. While a safe harbor plan can let you to maximize personal savings without risk of failed testing, they offer less plan design flexibility than a traditional plan – which can make it harder to meet certain plan goals. Below is a summary of key differences:

Requirement

Traditional 401(k)

Safe Harbor 401(k)

Eligibility 

Eligibility requirements for all plan contributions can be different.

To automatically pass the top heavy test, eligibility requirements for the safe harbor contribution must match the salary deferral requirements. 

Employer Contributions

Not required. Matching and profit sharing contributions may be subject to allocation conditions (e.g., 1,000 hours, employment on last day of plan year).

Required. One of the following contributions must be made to participants:

  • Nonelective Contribution – 3% (or more) of compensation, regardless of salary deferrals.
  • Basic Match – 100% of the first 3 percent of compensation, plus 50% on the next 2 percent (4% of compensation total).
  • Enhanced Match – Must be at least as much as the basic match at each tier of the match formula. 100% match on the first 4% of compensation is common.
  • QACA(1) Match – 100% of the first 1 percent of compensation, plus 50% on the next 5 percent of compensation (3.5% of compensation total).

HCEs can be excluded from safe harbor contributions, but allocation conditions can’t apply. 

Additional matching and profit sharing contributions permitted. The additional match can be exempt from the ACP test when certain conditions are met.

Vesting 

Up to 3-year cliff or 6-year graded vesting schedule permitted for employer contributions.

Safe harbor contributions are generally subject to 100% immediate vesting. However, QACA contributions may be subject to a 2-year cliff schedule.

ADP/ACP Testing

Required.

Not required unless one of the following conditions applies: 

  • Salary deferrals are subject to shorter eligibility requirements than safe harbor contributions.
  • A match that’s not exempt from the ACP test is made by the employer.
  • Voluntary (after-tax) contributions are made by participants.

Top Heavy Testing

Required.

Not required unless one of the following conditions apply:

  • Salary deferrals are subject to shorter eligibility requirements than safe harbor contributions.
  • A profit sharing contribution (including a forfeiture reallocation) is made by the employer.
  • A match that’s not exempt from the ACP test is made by the employer.
  • Voluntary (after-tax) contributions are made by participants.

Participant Disclosure

Not applicable

Must meet a participant disclosure requirement. The required safe harbor notice must include certain contribution and vesting information. Participants must receive this notice prior to plan eligibility and then 30-90 days before the start of each new plan year. 

(1)A Qualified Automatic Contribution Arrangement (QACA) is a type of automatic enrollment arrangement that incorporates a safe harbor match or 3% nonelective contribution.

What’s the Best 401(k) Choice for Your Company

Usually, a safe harbor 401(k) plan is the superior choice when your plan will fail annual testing – particularly the top heavy test.

Reasons to choose a safe 401(k) plan:

  • Your plan will be top heavy. Because a top heavy 401(k) plan must generally make a 3% minimum contribution to non-key employees, the 3% nonelective contribution will cost about the same. The 4% match might even cost less than the top heavy minimum contribution if participants defer at low rates.
  • Your plan will fail the ADP and/or ACP test. A safe harbor plan will allow HCEs to maximize annual contributions without risk of refund.
  • You want to offer a generous retirement benefit to employees.

Reasons to choose a traditional 401(k) plan

  • Your plan will have no trouble passing the ADP/ACP and top heavy tests.
  • You want to incentivize long-term employment by plan participants by adding allocation conditions (e.g., 1,000 hours, employment on last day of plan year) and/or vesting schedule to matching contributions.
  • You want to use a “stretch” match formula (e.g., 25% of salary deferrals up to 10% of compensation) to incentivize plan participants to make bigger salary deferrals. 

Know Your Options!

While safe harbor 401(k) plans are the most popular type of 401(k) used by small businesses, they are not the best fit for every small business. Sometimes, the 401(k) plan goals and budget of a business owner can be better met with the flexibility of a traditional plan. As a small business owner, you owe it to yourself to take the time to figure out which plan is best for you.