Posted on September 07, 2010
This article is written for employers who: (i) have a 401(k) plan; (ii) contribute (or have cash flow to contribute) at least 3% to 5% of employee compensation to the plan; and (iii) would like to differentiate the level of benefits for key employees (including owners) from the level of benefits provided to other employees. 401(k) plans are not new retirement plan vehicles. However, the Small Business Job Protection Act of 1996 created the “401(k) safe harbor.” In a traditional non-safe harbor 401(k) plan, employees may elect to defer part of their current compensation to the 401(k) plan. Certain administrative burdens and limitations on highly compensated employees’ deferrals are caused by the “actual deferral percentage” or “ADP” test. This test requires that the elective deferrals of nonhighly and highly compensated employees be calculated and the percentage of deferrals of the highly compensated group is limited by the average deferral percentage of the nonhighly compensated group.
The safe harbor 401(k) plan resolves the problems associated with the ADP test. The safe harbor plan is deemed to satisfy the ADP test. However, to obtain safe harbor status, the employer must meet two requirements: (1) a contribution and (2) a notice requirement. The contribution requirement is satisfied if the employer either contributes 3% of compensation for each eligible employee, without regard to whether the employee makes any elective deferrals, or in the alternative, the employer may match employee elective deferrals dollar-for-dollar up to the first 3% of compensation plus 50 cents on the dollar for the next 2% of compensation. For example, if an employee earns $30,000 annually and elects to defer 5% of pay, the matching cost to the employer would be $1,200 (the first 3% or $900 deferred by the employee would be matched with $900 by the employer and the next 2% or $600 deferred by the employee would be matched with $300 by the employer). Employees are immediately vested in the employer safe harbor contributions.
Within a reasonable time (generally no later than 30 days and no earlier than 90 days) before the start of the plan year, the employer must notify employees as to whether the safe harbor will be satisfied with the 3% or the matching contribution. Although the notice provision may appear to limit employer flexibility, employers with a history of contributing at least 3% of compensation to a retirement plan will not find this requirement burdensome. The question for these employers is how to leverage that contribution to maximize the retirement benefit for owners and other key employees.
The first leveraging benefit from the safe harbor 401(k) plan is that the owners and other highly compensated employees receive not only the safe harbor contribution, but may also maximize their elective deferrals ($16,500 in 2010) regardless of the actual deferral percentage, if any, of the other employees. The second leveraging benefit is that the employer contribution may also be taken into account to test whether the allocation of employer contributions discriminates unfairly in favor of owners and other key employees. For this second leveraging benefit, the safe harbor 401(k) is combined with a cross-tested allocation feature.
What is a cross-tested plan? To understand this retirement plan design, compare it to a typical profit sharing plan. A typical profit sharing plan will allocate the employer contribution pro rata on the basis of participant compensation. For example, if the employer contributes 5% of participant payroll to the retirement plan, each participant will have 5% of his/her compensation allocated to his/her account. The dollar amount of the contribution is greater for the highly compensated employees but the percentage of pay allocated to his/her account is the same percentage (5% in this example) as allocated for all participants.
Rather than test the contribution allocation (5% in the traditional profit sharing plan example above), a cross-tested plan tests the benefit to demonstrate compliance with the nondiscrimination rules. For example, assume a 25-year-old employee earns $30,000 per year. If 5% of his/her compensation, or $1,500, is contributed to a profit sharing plan for this employee’s benefit, the plan tests for nondiscrimination by assuming that the $1,500 will appreciate at the rate of 8.5% from the current contribution year through the time the employee attains age 65. For purposes of the example, assume that the $1,500 contribution would appreciate in value to about $39,000 by the time the employee attained age 65. This theoretical $39,000 could purchase a life annuity that would provide a benefit of approximately $2,700 per year for the life of the employee. No annuity would actually be purchased. This is a hypothetical that is calculated solely for testing purposes. At retirement or other distributable event, the participant receives the amount credited to his/her account at the time of distribution. The $2,700 hypothetical benefit is 9% of the employee’s current $30,000 per year compensation ($2,700/$30,000).
Now consider a 55 year-old owner-employee whose current compensation is $245,000 (the 2010 compensation limit). If $32,500 is contributed to the owner’s account and it is assumed that this contribution will appreciate at 8.5% until the owner attains age 65, the owner will have a benefit of approximately $73,500 or a hypothetical $8,600 per year annuity. This would replace only 3.5% of the owner’s current compensation ($8,600/$245,000). Consequently, while the owner is replacing only 3.5% of his/her current compensation, the employee is replacing 9%. This example demonstrates that the plan does not discriminate in favor of the owner or highly compensated employee even though the owner receives an allocation of 13.3% of current compensation and the other employees receive an allocation of 5% of current compensation.
Maximum leveraging results from a combination of the safe harbor 401(k) with the cross-tested plan. This occurs because the employer's safe harbor 401(k) contribution is counted as part of the cross-tested allocation. If we apply the cross-tested safe harbor 401(k) design to the example above, the key employee may receive an allocation of $49,000 (not counting any catch up deferrals, which may be made). This is achieved with: (i) $16,500 [elective deferrals under the safe harbor 401(k) plan] plus (ii) $7,350 [the employer's 3% safe harbor 401(k) contribution] plus (iii) $25,150 [the employer's discretionary profit sharing contribution allocated via cross-testing]. Again, looking to the example above, for the non-key employees, the employer contribution would be 5% of compensation. This 5% includes the 3% safe harbor 401(k) contribution plus approximately 2% to satisfy the cross-tested nondiscrimination and the minimum gateway contribution requirements. In this example, the employer has achieved a 20% benefit for the key employee (to reach the maximum $49,000 annual addition in 2010) at a cost of 5% of non-key employee compensation.
The employer contribution to the cross-tested profit sharing plan is discretionary. The employer determines whether and how much to contribute as its profit sharing contribution to the plan on a year-to-year basis. The cross-tested 401(k) plan may be advantageous for employers who: (i) have a history of contributing approximately 5% per annum to a retirement plan; and (ii) owners who are older than the average age of their employees.
Generally, existing 401(k) plans may convert to a safe harbor 401(k) plan at the start of the year. The employer may make amendments to incorporate cross testing allocation provisions during the current plan year and prepare the plan to implement the safe harbor feature for the next plan year.
If you would like to discuss this topic in more detail, please call David M. Mosier at 814-459-2800.