The term “safe harbor” is used throughout the Internal Revenue Code (IRC) regarding retirement, but what does this term mean? The term safe harbor in relation to a retirement plan means if the plan follows certain requirements the IRC testing requirements are deemed to pass or be satisfied. We will discuss a few of the ways the term safe harbor is used in the IRC.
Safe Harbor 401(k) Plan
Many people are familiar with “safe harbor 401(k) plans.” This means, if the plan meets certain requirements it is deemed to pass many of the required IRC nondiscrimination tests. Some of the nondiscrimination tests deemed to pass are listed below:
Actual deferral percent (ADP) test – The Highly Compensated Employees (HCEs) may only make salary deferral contributions as a percent based on the salary deferral contribution percent of the Non-Highly Compensated Employees (NHCEs).
Actual contribution percent (ACP) test – The HCEs may only receive an employer matching contribution based on the matching contribution percent received by the NHCEs.
Top-heavy minimum contribution – A plan is considered top-heavy if key employees have 60% or more of the plan assets. If a plan is top-heavy, a 3% employer contribution is required to all non-key employees.
To satisfy the safe harbor requirements, the employer is only required to make a 100% vested employer match or non-elective contribution to plan participants without any allocation requirements. They must also provide an annual notice to all plan participants notifying them of the safe harbor contribution.
Safe Harbor Hardship Distributions
If the plan adopts the Safe Harbor Hardship Distribution rules, the hardship distributions are deemed to satisfy the hardship rules. The safe harbor hardship reasons are listed below:
Medical expenses for the employee or the employee’s spouse, dependents, or beneficiary
Costs directly related to the purchase of an employee’s principal residence (excluding mortgage payments)
Tuition, related educational fees, and room and board expenses for the next 12 months of postsecondary education for the employee or the employee’s spouse, children, dependents or beneficiary
Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure on the mortgage on that residence
Funeral expenses for the employee or the employee’s spouse, children, dependents, or beneficiary
Certain expenses to repair damage to the employee’s principal residence
If a hardship distribution is for one of the above reasons it will not be questioned by the Internal Revenue Service (IRS) due to it being a safe harbor distribution reason.
Safe Harbor Contribution Formula
The allocation formula plans use to allocate any profit sharing contribution must be tested for discrimination under IRC Section 401(a)(4). If the plan fails the IRC 401(a)(4) nondiscrimination test the allocation must be corrected. The IRC provides that certain plan allocation formulas are deemed to be safe harbor. If a plan uses an approved safe harbor formula, the IRC 401(a)(4) nondiscrimination test is deemed to pass regardless of the testing results. Plans do not perform the IRC 401(a)(4) nondiscrimination test since it is deemed to pass. A couple of the most common safe harbor allocation formulas are listed below:
Please call us to discuss any of the safe harbor items discussed in this article.