A 401(k) plan, or some other type of retirement savings vehicle, has become an imperative for most employers. Among the biggest challenges organizations face when implementing a 401(k) is managing the complex array of IRS rules for nondiscrimination testing regarding elective deferrals and matching contributions.
Some employers may be able to automatically pass nondiscrimination testing by creating a safe harbor 401(k) plan. However, a common question that arises when considering this move is: Can a safe harbor 401(k) become top-heavy?
Exempt vs. nonexempt
According to the IRS, “A plan is top-heavy when the owners and most highly paid employees (‘key employees’) own more than 60% of the value of the plan assets.”
A safe harbor 401(k) that has only elective deferrals and safe harbor matching contributions is generally exempt from being top-heavy. If the plan is making a nonelective contribution of 3% to all employees, it automatically satisfies the top-heavy contribution requirement.
However, a safe harbor 401(k) with matching contributions isn’t exempt from being top-heavy if:
- The plan allows for a discretionary nonelective contribution to be made and one is actually made,
- Forfeitures are allocated to participants in the same manner as nonelective contributions, or
- Employees can defer immediately but aren’t eligible for a matching contribution until after one year of service is completed. (This is uncommon.)
Thus, nonexempt safe harbor 401(k) plans can easily become top-heavy because key employees can receive maximum contributions. If a plan becomes top-heavy — and a key employee defers or receives an allocation of a certain percentage — the employer must provide an allocation of that percentage to all eligible non-key employees.
Furthermore, if the plan is making a safe harbor matching contribution — and it’s not considered exempt — you’ll need to make extra contributions of the required percentage for the eligible employees who aren’t deferring and for the participants who are deferring less than that required percentage.
Not a simple decision
As you might suspect, establishing or converting to a safe harbor 401(k) plan is hardly simple. For example, to immediately start one, the new plan must have at least three months remaining in the short plan year. Otherwise, you’ll have to wait until the next plan year to add it, and it won’t be effective until the following plan year.
Nonetheless, the thought of avoiding nondiscrimination testing requirements may be enticing. Just be sure you understand these and all other requirements of a safe harbor 401(k) plan before you commit to the implementation process.
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