Know Your Safe Harbor Plan Design Options, Part 2
For employers that choose to operate 401(k) Safe Harbor Plans to encourage all employees to enjoy the tax advantages available to contributing participants, we shared two Safe Harbor Plan design options and their benefits in a previous blog. Today we’ll look at a third Safe Harbor Plan design that provides additional benefits to employers and encourages greater participation and deferrals (contributions) on the part of plan participants.
This 401(k) Safe Harbor Plan option is referred to as a QACA, which stands for a Qualified Automatic Contribution Arrangement.
As a refresher, 401(k) plans must pass non-discrimination tests that include the Actual Deferral Percentage or ADP test and the Actual Contribution Percentage or ACP test, and must not be “top-heavy,” meaning no more than 60 percent of the plan’s assets may be in the accounts of what the IRS defines as key employees. Failing discrimination testing can require refunds of deferrals to highly-compensated employees or corrective company contributions. Operating under a “safe harbor” allows a 401(k) Plan to automatically pass discrimination testing.
The two Safe Harbor Plan options we discussed previously allowed employers to make either non-elective or matching contributions to pass discrimination testing.
The QACA 401(k) Safe Harbor Plan likewise allows employers to choose between making a 3% non-elective contribution to all eligible participants or a matching contribution to deferring participants.
- Like the Non-Elective Safe Harbor Plan, the QACA Non-Elective Safe Harbor Plan is a good alternative for employers that intend also to make a profit-sharing contribution. This is because the 3% safe harbor non-elective contribution may be applied toward any minimum contribution required to allow a company to vary its profit-sharing contributions to different employee groups.
- The QACA Match differs in that its required maximum is lower (3.5%) than the required maximum (4%) of a non-QACA match. However, a QACA plan often results in higher participation rates, and companies must be aware that this can increase their total required contribution to the plan. The QACA match requires employers to match 100% on the first 1% of deferred compensation and 50% up to 6% of deferred compensation.
The QACA 401(k) Safe Harbor Plan often results in higher participation rates because employers automatically enroll employees as they become eligible. The initial default deferral must begin at no less than 3% and increase at least 1% annually to no less than 6% (with a maximum of 10%). A simple alternative to the automatic enrollment and escalation combination is to automatically enroll employees at a default deferral rate of 6% with no annual escalation. An automatic enrollment notice will be provided to participants as they become eligible to participate in the plan. Participants have the ability to “opt-out” and, in some cases, obtain a refund of any automatic deferrals.
While contributions made to the Safe Harbor Non-Elective and the Safe Harbor Match Plans is immediately vested, meaning participants “own” them as soon as they are made, the QACA Safe Harbor Plan allows employers to create as much as a two-year “cliff” vesting schedule. This means that a participant must complete two years of service, as defined by the plan, before they own the employer’s safe harbor contributions. Many employers like the vesting schedule because it rewards longevity and encourages valued employees to remain with the company.
A 401(k) QACA Safe Harbor Plan is advantageous in helping employees – like any automatic enrollment plan – in that it overcomes the inertia that prevents many employees from enrolling in the 401(k) plan.
Some employers express reluctance to act on behalf of employees and enroll them in the 401k plan. However, surveys of employees find overwhelmingly that they appreciate employers making it easier for them to save for retirement. And, automatically enrolled employees have the choice to opt out.
Some employers also hesitate to default employees to defer as much as 6% of their income, even though employees may change their deferral rate. Studies support a 6% automatic deferral, showing there is little difference in opt-out rates when employees are enrolled at 6% versus 3%. Also, given that 15% of income has been defined as an optimum annual savings rate, 6% places employees closer to reaching a financially secure retirement.
The decision of which 401(k) Safe Harbor Plan makes sense for your company may be made working with a knowledgeable plan advisor and an expert Third Party Administrator. Don’t forget as well to review plan testing to determine if it’s possible to operate without a safe harbor. Creative contribution strategies exist for non-Safe Harbor plans to encourage greater participation and deferrals.
This blog is written to help make the lives of plan sponsors easier in the process of meeting legal requirements under ERISA for their defined contribution plans. Please understand that reading this blog should not alone take the place of a one-on-one consultation regarding the needs of your specific plan, and hence cannot be a guarantee against fiduciary breaches.