Are the 401(k) rules limiting your ability to take full advantage of tax-deferred retirement benefits? Or have you forgone establishing a 401(k) plan for your business because of the cost and complexity of complying with nondiscrimination testing? If so, then consider a safe harbor plan.

These plans allow businesses to not only maximize benefits for owners, related family member employees and other highly compensated employees (HCEs) but also avoid nondiscrimination testing. In exchange, employers must make certain required contributions to the plan.

HCE Limits

Ordinarily, 401(k) plans must comply with nondiscrimination rules designed to prevent them from favoring HCEs over non-highly-compensated employees (NHCEs). If elective salary deferrals or employer contributions for HCEs are substantially greater than those for NHCEs, the employer may have to reduce (or return) deferrals or contributions for HCEs, increase contributions for NHCEs, or both. Here’s an example:

Sam and his daughter, Dana, each own 50% of S&D Inc. Sam, 55, earns $200,000 per year and Dana, 30, earns $150,000. They have five employees, each earning $50,000. Two of the employees defer 10% of their salaries, or $5,000, to the company’s 401(k) plan. The other three employees, although eligible, don’t participate in the plan, so average deferrals for the five NHCEs are 4%.

For 2015, the maximum elective deferral to a 401(k) plan is $18,000 ($24,000 for employees aged 50 or older). But the nondiscrimination rules provide that average deferrals for HCEs must not exceed average deferrals for NHCEs by more than two percentage points. So the most Sam and Dana can defer is 6% — $12,000 and $9,000, respectively.

This results in an additional $21,000 of Sam and Dana’s aggregate income being subject to income taxes. If the company were to establish a safe harbor 401(k) plan, the nondiscrimination rules wouldn’t apply, allowing Sam and Dana to defer the maximum amount ($42,000!) plus receive the safe harbor match.

Safe Harbor Rules

To qualify for the safe harbor, an employer must either:

1. Make nonelective contributions equal to 3% of compensation for all eligible employees, regardless of whether they make elective deferrals, or
2. Match employees’ elective deferrals as follows: 100% of the first 3% of compensation deferred, and 50% of the next 2% deferred.

Contributions must vest immediately and participation cannot be contingent on minimum hours of service or employment on the last day of the plan year. Several other requirements apply.

Right for Your Business?

For business owners seeking to maximize 401(k) benefits for themselves and for family members working in the business, a safe harbor plan may be the answer. If you’re willing to make employer contributions (or you’re already doing so), and don’t object to immediate vesting, a safe harbor plan can help you lower your administrative costs and increase the amount of income you can defer from being subject to income taxes.

To learn more about safe harbor plans and other options that can help business owners maximize their tax-advantaged retirement savings, please contact us.