Every year, the IRS comes out with the new annual retirement plan limits. Some of these limits provide in part; the maximum individual contribution to Solo 401k, 401(k), 403(b) or 457 plans; the maximum compensation taken into consideration for retirement plan allocations and deductions; and the social security wage base.
Investment representatives and retirement service providers will be hailing the new limits as an opportunity for employees to save more money in their retirement plans on a tax deferred basis. Following that advice may be a mistake for highly paid employees and could cost their employer additional fees.
Following the advice, highly compensated employees, with higher discretionary income levels, would increase their contributions. The non-highly compensated employees, with little discretionary income, will maintain their contributions at the current levels. The net result is a failed Non Discrimination test (The Average Deferral Percentage Test) with the required subsequent refunds to the highly compensated and additional employer fees.
The Safe Harbor
Instead of touting the new plan contribution limits alone, investment representatives need to include the “Safe Harbor” plan design benefits with them.
401k Safe Harbor Benefits
Adopting a safe-harbor 401(k) plan design permits an employer to avoid 401k discrimination testing of the rates of employee elective deferrals and/or employer matching contributions (ADP / ACP testing). The benefit for avoiding testing is maximized contributions for the highly compensated. The safe harbor plan design waives the need for non discrimination testing and permits the company owners or those earning over $90,000 a year to contribute up to $20,000 to the plan on a tax deferred basis in 2006. With the 401k Safe Harbor design, the employer matching contribution can also be used to satisfy any top heavy requirements. (A plan is top heavy when more than 60 percent of the assets are held by the owners and key employees. A top heavy plan is required by the IRS to give all eligible plan participants an additional contribution equal to the lesser of one-third of the contribution received by the highest paid key employee or 3 percent of compensation).
Two Types of 401k Safe Harbor Designs.
One type is the 401k safe-harbor non-elective design of 3% of compensation. Generally, a 3% contribution is provided to all employees eligible to make elective deferrals to the plan. The guaranteed contribution requires that a 3% employer contribution be made each plan year, unless the employer amends the plan and removes the provision before the start of the new plan year. The 3% is 100% employee vested.
The other type of 401k safe-harbor design is a matching contribu
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