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IRS Issues Guidance on 401(k) Safe
Harbor Rules
Shirley Dennis-Escoffier
ince the passage of the Small Business Jobs Protection Act of 1996, there were
dreams in deferred compensation circles of the day that 401(k) plans would
meet the contribution safe harbor provisions of the Act eliminating the annual
chore of nondiscrimination testing. Now that the Internal Revenue Service (IRS)
has issued its long-awaited guidance on these safe harbor rules, it is being greeted
with mixed reactions.
Beginning in 1999, it is possible to design a 401(k) plan so that it is not subject
to the burdensome average deferral percentage or average contribution percentage
tests of the Internal Revenue Code. Plans that meet the safe harbor rules will
reduce administrative costs by avoiding the need to conduct these tests.
Additionally, highly compensated employees will know at the beginning of the
plan year the maximum elective contributions and matching contributions that
can be contributed on their behalf, preventing the need to make corrective
distributions to these employees when the tests are not passed. However, some
experts now complain that these rules are too onerous and that few employers will
be interested in upgrading their 401(k) plans to qualify for the safe harbors. Thus,
it is important for anyone considering adoption of these rules to look carefully
before leaping into the safe harbor waters.
Shirley Dennis-Escoffier, Ph.D.,
CPA, is an associate professor of
accounting at the University of
Miami in Coral Gables, Florida. She
previously worked in public
accounting and for several
corporations. She has published
numerous articles in tax journals.
One of the most popular retirement savings vehicles is the 401(k) plan, which
allows eligible employees to contribute a portion of their current compensation
on a pretax basis (elective contributions), and in many cases, receive employer
matching and other contributions as well. Despite their popularity and the
significant tax advantages to both the employer and employee, there are some
drawbacks to maintaining a 401(k) plan. In addition to the administrative
burdens and complexities associated with maintaining a qualified retirement
plan, 401(k) plans are subject to additional limitations. The elective contributions
CCC 1044-8136/99/1003173-05
© 1999 John Wiley & Sons, Inc.
Shirley Dennis-Escoffier
under a 401(k) plan must annually satisfy the actual deferral percentage
(ADP) test, which limits the amount by which the average elective
contributions by the group of highly compensated employees (HCEs) can
exceed the average elective contributions by the group of nonhighly
compensated employees (NHCEs). A similar test, known as the actual
contribution percentage (ACP) test, applies if a plan provides employer
matching contributions and/or employee after-tax contributions.
To reduce the complexity for existing 401(k) plan sponsors and to encourage
more employers to adopt 401(k) plans, safe harbors for the ADP and ACP tests
were added by the Small Business Job Protection Act of 1996. This act amended
Section 401(k) and (m) saying a plan will automatically satisfy both the ADP and
ACP tests if it satisfies one of two alternative safe harbor contribution requirements
and an employee notice requirement, thus significantly reducing the
administrative burdens of maintaining a 401(k) plan. Since these changes were
not effective until plan years beginning in 1999, they have generally been ignored
until now. Also, until specific IRS guidance was issued, no one knew how difficult
it would be to navigate the specific requirements of these safe harbor rules. In late
1998, the IRS finally issued Notice 98-52 providing the specific requirements for
employers wishing to comply with the ADP and ACP safe harbors.
Beginning with the 1999 plan year, 401(k) plans will be deemed to satisfy the
ADP and ACP tests if the plan satisfies minimum contribution rules and
provides all eligible participants with a written notice of their rights and
obligations under the plan within a reasonable period before the plan year. The
minimum contribution rules can by satisfied by making one of the following
1. An employer matching contribution of at least 100 percent of elective
employee contributions up to 3 percent of compensation and 50 percent
of elective employee contributions up to the next 2 percent of
compensation; or
2. A nonelective (i.e., profit sharing) employer contribution of at least 3
percent of compensation for all eligible NHCEs.
There are also other limitations that apply to the matching contributions.
The plan must specify the match that will be used to satisfy the ADP safe harbor.
Although discretionary matching contributions may not be used to satisfy this
requirement, when a plan does satisfies the ADP safe harbor, additional
discretionary matching contributions will be permitted. However, effective
January 1, 2000, a plan would fail to satisfy the ACP test safe harbor if the plan
provides for matching contributions made at the employer’s discretion on
behalf of the employee that, in the aggregate, could exceed a dollar amount equal
to 4 percent of the employee’s compensation. IRS Notice 98-52 provides the
following example for this provision:
Beginning January 1, 2000, Employer B maintains only one plan, which
contains a cash or deferred arrangement that satisfied the ADP test safe
harbor using a 3 percent nonelective contribution. The plan also provides
The Journal of Corporate Accounting and Finance/Spring 1999
that Employer B may make, in its discretion, additional matching
contributions up to 50 percent of each employee’s elective contributions
that do not exceed 6 percent of compensation. This plan will satisfy the
ACP test safe harbor because, under the plan, the amount of discretionary
matching contributions could not exceed 4 percent of an employee’s
The safe harbor contributions must be fully vested at all times and subject to
certain distribution restrictions. The distribution restrictions are generally the
same that apply to any qualified nonelective employer contributions (i.e., they
can only be distributed on the employee’s termination of employment, death,
disability, or attainment of an age not less than 59 1/2).
Notice 98-52 also addressed the notice to participant requirements. A notice
must generally be provided to all eligible participants within a reasonable period
before the beginning of each plan year. This timing requirement will be considered
satisfied if the notice is provided at least 30 days and no more than 90 days before
the beginning of each plan year (with similar time frames for newly-eligible
participants during a plan year). At a minimum, the notice provided to all
eligible participants must accurately describe the following information:
1. The safe harbor matching or nonelective contribution formula used
under the plan (including a description of the levels of matching
contributions, if any available under the plan),
2. Any other contributions under the plan (including the potential for
discretionary matching contributions),
3. The plan to which safe harbor contributions will be made (if different
from the 401(k) plan),
4. The type and amount of compensation that may be deferred under the
5. The procedures for making cash or deferred elections, including any
administrative requirements that apply to such elections,
6. The period available under the plan for making cash or deferred
elections, and
7. The withdrawal and vesting provisions applicable to contributions
under the plan.
IRS Notice 98-52 provides additional guidance to plan sponsors in that it
addresses the timing of safe harbor contributions, the interaction of the safe
harbor methods with other qualification rules and testing methods, and how the
safe harbor methods work where an employer maintains multiple plans.
Whether converting to a 401(k) safe harbor arrangement makes any sense
depends on whether the savings produced from eliminating the ADP or ACP
testing exceed the increased cost (if any) of making the safe harbor employer
contribution, providing full vesting, and satisfying the employee notice
requirement. Many commentators have dismissed the 401(k) safe harbor as
requiring too high a rate of employer contribution to be of any practical use to
mainstream 401(k) plan sponsors. Companies now typically match only 50
The Journal of Corporate Accounting and Finance/Spring 1999
Shirley Dennis-Escoffier
percent of employees’ deferrals up to 6 percent of compensation. Because of the
generosity of the required match, many employers may not be interested in
upgrading their 401(k) plans to qualify. In addition, while employers typically
provide for matching contributions to vest within three to five years, to qualify
for the safe harbor, matching contributions will have to vest immediately.
These requirements may not be a problem for employers that already have
rich matching features and low turnover, and thus would not be greatly affected
by immediate vesting. Having such a plan could give an employer an edge in
recruiting highly paid employees because the employer could promise those
employees that they always could defer the maximum—currently $10,000 a
year—to the 401(k) plan. By contrast, in a traditional 401(k) plan, the IRS
nondiscrimination rules often hold back deferrals by highly paid employees if
those deferrals exceed by a certain prescribed amount deferrals by rank and file
employees. The safe harbor 401(k) plans may also appeal to employers that are
reexamining their benefit plans and may, for example, want to shift more dollars
into their 401(k) plans and allocate less for other plans.
Administratively, the plans will appeal to employers that do not want the
hassle of running nondiscrimination tests. Some employers may have already
discovered that the risk of failing the current tests and having to make some sort
of midyear adjustment in the preferred average deferral percentage of the HCEs
or face the prospect of making corrective contributions or distribution to HCEs
may exceed the cost of compliance with current rules.
For small employers with top-heavy test problems, the safe harbor provision
may be just what they need. IRS top-heavy rules ensure that the aggregate
account balances of the key employees and owners do not exceed 60 percent of
the total 401(k) plan assets. Currently, plan sponsors with top-heavy plans have
to pay a 3 percent across-the-board contribution to get around the top-heavy
test. However, these plan sponsors still have to pass the ADP and ACP tests. The
IRS has said that by electing option 2, plan sponsors automatically pass the topheavy test. This does not apply for option 1. By electing option 2, plan sponsors
can now put in the 3 percent as they have in the past, yet forget about the ADP
and ACP tests.
A safe harbor 401(k) plan could also be a good stepping stone for growing
companies that would like to move from a SIMPLE plan to a 401(k) plan.
Although the safe harbor 401(k) plans are more complicated than the SIMPLE
plans, they allow employees to defer more and for employers to provide a larger
match. For example, employees in a SIMPLE plan can only defer $6000 per year
as compared to $10,000 with a 401(k).
Although the safe harbor provisions may eliminate the administrative
hassles of annual ADP and ACP tests, they may create other administrative
headaches. For instance, the matching contributions are to be based over the
course of a year. So, for example, if an employee earning $20,000 annually
contributed 5 percent of her pay to a plan ($1000 a year) and the employer
selected option 1, the employer would have to provide a 4 percent match. If the
employee stopped contributing after six months, she would have contributed
$500 and the match would be $400. However, the IRS requires the $500
contribution to be based over the entire year and would require the company at
the end of the year to “true up” the match to $500 (i.e., a 100 percent match of
contributions less than 3 percent of compensation). This “true up” differs from
The Journal of Corporate Accounting and Finance/Spring 1999
the way most 401(k) plans are administered. Currently most companies provide
the match on a paycheck-to-paycheck basis, with no tally at the end of the year.
The IRS has issued guidance necessary for employers to adopt the ADP and
ACP safe harbors for 401(k) plans. The benefits to adopting a safe harbor plan
are potentially significant; namely, reduced administrative burdens from not
having to perform annual testing and certainty for the HCEs that their elective
contributions and matching contributions will not have to be reduced after the
close of the plan year. However, the employer must satisfy the safe harbor
requirements, which come with their own costs—primarily the additional costs
to the employer (if any) of making the safe harbor contributions and immediately
vesting those contributions. An employer must weigh those costs and benefits to
determine whether a safe harbor plan makes sense. ♦
The Journal of Corporate Accounting and Finance/Spring 1999
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