The popular 401(k) plan is available in more than one variety. For example, employers can use either a traditional or a safe harbor 401(k) plan. Both allow:
- Pretax contributions.
- After-tax contributions via the addition of a Roth 401(k).
- Catch-up contributions by participants age 50 or older.
- Participant loans.
- Profit sharing.
Selecting the right plan means weighing the pros and cons for your specific business. In general, small businesses tend to favor safe harbor plans. According to a study by Employee Fiduciary, 68% of small businesses “use a safe harbor 401(k) plan design to avoid annual “actual deferral percentage/actual contribution percentage” (ADP/ACP) and “top-heavy” tests.
Small companies often fail those tests because the owners usually hold a large portion of the company’s assets. When the tests fail, the company must generally issue corrective refunds or make additional contributions to nonowners. A safe harbor 401(k) plan eliminates or drastically minimizes those consequences.
However, safe harbor 401(k) plans have limitations, including being subject to rigid contribution and vesting requirements — which can be costlier for smaller companies than a traditional 401(k) plan is.
Below is a list showing the key differences between the two kinds of plans:
1. Employer contributions
Traditional 401(k): Employer contributions are optional. Employers can choose to make contributions for all participants (even those who are not contributing), make matching contributions according to participants’ elective deferrals or to do both.
Safe harbor 401(k): Employer contributions are mandatory. Employers must make either a matching contribution or a nonelective contribution, up to the contribution limits set by the IRS.
Traditional 401(k): Employer contributions can be subject to a vesting schedule — meaning participants do not own the contributions you make to their account until after a certain period of time. Or employer contributions can be instantly vested — meaning participants immediately own all the contributions you make to their account.
Safe harbor 401(k): Employer contributions cannot be subject to a vesting schedule — meaning participants own all the contributions you make to their account the minute they are made.
3. ADP/ACP testing
Traditional 401(k): Employers must perform and pass annual ADP and ACP nondiscrimination tests to ensure compliance with the 401(k) rules for highly compensated employees.
Safe harbor 401(k): Employers do not have to conduct annual ADP and ACP nondiscrimination tests.
4. Top-heavy testing
Traditional 401(k): Employers must perform annual top-heavy testing to ensure “key employees” do not own more than 60% of the total plan assets. If the plan is deemed top-heavy, the employer may need to make a minimum contribution for each non-key employee.
Safe harbor 401(k): Employers are normally not subject to top-heavy testing. Exceptions are rare, such as when an employer makes discretionary profit-sharing contributions.
If you’re not sure which of the two plans to pick, ask a benefits expert for advice.