Here at Gusto, we want our clients to have all the available information and support they need to thrive as business owners and financial advisors. That’s why we’re thrilled to bring you expert knowledge about how non-discrimination testing and the safe harbor plan affect 401(k)s for SMBs.
The webinar “401(k)s and Why Small Businesses Should Start a 401(k)” provided premium education for accountants and business owners alike — equipping individuals with a well-rounded understanding of retirement investments and the pros and cons of starting a 401(k) for a small business.
The host for this event was Nicolle Willson, Head of Retirement Consulting at Guideline. Together, they will walk you through the ins and outs of 401(k)s, how they benefit small businesses, how the SECURE Act and CARES Act is impacting retirement investments, and the ins-and-outs of non-discrimination testing and the safe harbor plan.
This event covered several features related to 401(k)s and SMBs, which were broken down into three different parts. In Part One, they cover 401(k) basics and why small businesses should start one. In Part Two, they dive into how the SECURE Act and CARES Act affect 401(k)s for SMBs. And finally, Part Three, which this article covers, discusses non-discrimination testing for 401(k) plans and the safe harbor plan.
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What is non-discrimination testing for 401(k) plans?
Have you heard this term when it comes to discussing your 401(k) plan options? What does it mean? Here’s how Nicolle from Guideline summed it up:
Non-discrimination testing is a fancy of way of saying 401(k) plans have required annual tests to ensure that retirement plans benefit all employees and not just owners and executives. If you fail non-discrimination testing, you have to make corrections to the plan which can involve refunds or corrective contributions of some sort.– Nicolle Willson
There are three tests that fall under non-discrimination testing which are the ADP test, the ACP test, and the top-heavy test.
The ADP and the ACP
The ADP test stands for “actual deferral percentage,” and ACP stands for “actual contribution percentage.” Both tests focus on highly compensated employees (HCEs) versus non-highly compensated employees (NHCEs).
- An HCE is someone who owned more than 5% of the business at any time during the year or the year before, OR it’s someone who made at least $125,000 in the previous year. An HCE falls within the top 20% of employees, ranked by compensation.
- An NHCE is anyone who is not an HCE.
The ADP test examines how employees differ by their pay and the ACP test looks at matching contributions — these calculations are a bit difficult to explain, but Nicolle provided an excellent summary:
In general, … [they look] at what the average HCE is contributing or getting versus what the average NHCE is contributing or getting. So you’re grouping them in two different categories, you’re averaging their percentages together in a group, and then you’re comparing those percentages. If HCEs are getting too much more [of the] benefit, that’s usually … going to end up being more than 2% higher than what NHCEs are getting, then that’s when you’re going to need to make corrections. The corrections are typically going to be refunds back to HCEs, but alternatively, you can make employer contributions to NHCE accounts to bump up the average.– Nicolle Willson
In summary, as a business owner or financial advisor, you need to ensure that HCEs and NHCEs are receiving and contributing similar amounts to the business 401(k) in order to not fail ADP and/or ACP testing.
The top-heavy test
Different from ADP and ACP, the top-heavy test focuses on key employees instead of HCEs.
- A key employee is someone who is either an officer making $185,000 in a certain year, OR
- Someone who owns more than 5% of the business, OR
- Someone who owns more than 1% of the business and makes over $150,000 for the year.
[In the top-heavy test,] we’re looking at [a key employee’s] account balance on one specific day as opposed to contributions throughout the year. … We look at status for the current plan year, whereas [with] HCEs, we’re looking at the preceding plan year. … [The] top-heavy test is a bit easier to understand. So if key employees have more than 60% of the entire plan’s balance in their accounts on 12/31 of a given year, that plan is ‘top heavy’ for the next year. So on 12/31/19, if my plan key employees had 65% of the entire balance, then the plan is going to be ‘top heavy’ for the entire 2020 year.– Nicolle Willson
If your 401(k) plan is deemed “top-heavy,” then you will have to pay a 3% contribution to non-key employee accounts for the year they are top-heavy. These contributions can be really steep, and they can definitely add up in expenses for small businesses.
How can small businesses avoid failing non-discrimination testing?
Small businesses are most at-risk for failing these non-discrimination tests, so what can they do about it?
First of all, business owners can decide not to contribute or contribute very little to their own retirement accounts. Second, business owners (partnered with their accountants) can personally ensure that key employees, HCEs, and NHCEs receive close to the same benefits from the business 401(k).
The third option is a bit more attractive! Business owners can start a safe harbor plan.
What is a safe harbor 401(k) plan?
If you’re worried about failing non-discrimination testing, starting a safe harbor plan is a great way to ensure you’re not liable for any refunds or contributions.
A safe harbor plan gives employees an employer contribution in the designated formula, and that’s going to be written into the plan document. In exchange, the 401(k) plan is going to be exempt from all that non-discrimination testing we just talked about, and business owners and executives aren’t going to have to worry about minimizing their own contributions.– Nicolle Wilson
Rather than worrying about calculating the percentages of 401(k) benefits yourself, you can have a safe harbor plan do it for you! Plus, there are two plans you can choose from, depending on your business needs.
The traditional safe harbor plan
Traditional safe harbor plans are essentially 401(k) plans that have a stated amount of employer contribution that must be paid in full in the plan year in order to maintain safe harbor status.
In terms of employer contributions, you’re going to choose either a match or what’s called a ‘non-elective contribution.’ The most common safe harbor match is called the basic match. This is a tiered match of 100% of contributions up to 3% of pay, and 50% of contributions from 3% to 5% of pay. So basically, an employee is going to contribute at least 5% of pay if they want to get the max match of 4%.– Nicolle Wilson
Alternatively, you can choose the “enhanced match option,” the most popular of which is 100% of contributions up to 4% of pay. And lastly, you can opt for the non-elective contribution:
The non-elective is going to be paid to all eligible employees regardless of whether they contribute their own money, but it is a slightly lower minimum for that at 3% of pay.– Nicolle Wilson
Within the traditional safe harbor plan, there are three options of how to pay your contributions, making it a popular choice for small business owners and accountants alike.
The QACA safe harbor plan
Standing for “qualified automatic contribution arrangement,” the QACA safe harbor plan gives employers even more flexibility; however, they are a bit more complicated. You also must have auto-enrollment for your 401(k) plan in order to be eligible for the QACA safe harbor plan — this is what decreases the amount of contribution you must pay.
Here’s how Nicolle explained it:
So typically the default contribution rate starts at 3% and will increase every year until the employee hits 6%. And then in exchange for adding auto-enrollment, the matching contribution can decrease. You only need to contribute 100% up to the first 1% of pay and then 50% from 2 to 6% of pay. So this means the employee must contribute at least 6% of pay, and they get the maximum match of 3.5%, which is a half percent less than the traditional basic match. Alternatively, you can also do the 3% more collective contribution.– Nicolle Willson
In addition to decreased contribution rates, QACA safe harbor plans allow for a vesting schedule of up to two years, while traditional safe harbor plans have immediate vesting no matter what.
Additional regulations of safe harbor plans
Before we wrap up, there are a few more things you need to know about safe harbor plans before starting one for your business 401(k).
They have strict deadlines.
If you are starting a brand new 401(k) plan with a safe harbor plan attached, you must start this plan by October 1 of any given year. If you have an existing plan and you’d like to add a safe harbor plan to it, you must do this before 1/01 of any given year.
The IRS is really strict on this. There are no exceptions to these deadlines.– Nicolle Willson
Safe harbor match plans must provide notice annually within a reasonable amount of time.
When choosing a match plan, you must provide notice at least 30 but not more than 90 days before the beginning of the plan year.
Corresponding to these most popular start dates for 10/01 plans, you have to give notice by September 1. And for 1/01 plans, you have to get noticed by December 2 of the previous year.– Nicolle Willson
There’s one exception to this rule: the SECURE Act has removed the notice requirement for safe harbor non-elective plans and you can add a non-elective plan any time during the year as long as you pay the contributions at the start of the year.
This is great news for a lot of small businesses because this means they can start a plan without safe harbor, and if they find out that they’re in danger of failing any non-discrimination tests like midway through the year, they can add a non-elective contribution and the plan now becomes safe harbor. This is way more flexible than it used to be.– Nicolle Willson
QACA safe harbor plans will still require a strict 30-day notice requirement for auto-enrollment, so you generally can’t add the QACA plan mid-year.
Employers can’t deduct employer contributions that exceed 25% of eligible payroll for the year.
If employers contribute over this amount to the plan in the form of matching or profit-sharing, the excess can be carried forward to the next year; however, they will be subject to a 10% excise tax.
Want to learn more about 401(k) provisions and plans for your small business?
There are a number of ways 401(k)s add value to small businesses and are easier than ever to set up! Plus, with safe harbor plans, you can ensure your business doesn’t fail non-discriminatory testing. If you’re an SMB, connect with your accountant to discuss how this plan can benefit you and your business 401(k).
If you’re an accountant, we hope that this provided valuable information that helps you advise your clients.
If you want to learn more about 401(k)s and how they benefit small businesses, make sure to check out the full webinar here. Additionally, make sure to check out Part One of the webinar, “Basics and Why Small Businesses Should Start with a 401(k),” and Part Two, “How the SECURE Act and CARES Act Affect 401(k)s for SMBs,” for valuable information regarding 401(k)s and how COVID-19 legislation will impact retirement investments.