Safe Harbor vs. traditional 401(k) plans: Which is right for you and your Employees?

Weigh the pros and cons of each carefully before making a decision for your company.

401(k) lingo can sound like a foreign language. There's "MEPs" and "PEPs," “QDIAs” and “QACAs.” But for now, let's focus on Safe Harbor 401(k) plans. If you’ve concluded that a 401(k) is right for your company, the next decision you face is what kind of 401(k) plan. The two most common are the traditional 401(k) and the Safe Harbor variety, which offers an alternative to it.

Does the “Safe Harbor” name mean the traditional route is riskier? Not necessarily. There's a host of pros and cons to each plan type. The best fit for your company depends ultimately on your unique situation. Keep reading to try on a Safe Harbor for size.

Editor’s note: If you’re reading this during the first half of the year, with eyes on possibly implementing a Safe Harbor plan the following year, time is of the essence! Learn more about Safe Harbor setup deadlines below.

 Safe Harbor plans offer companies an enticing deal. Contribute to your employees’ 401(k)s, the federal government says, and we’ll give you a free pass on most compliance testing. There's plenty more nuance to them of course (keep reading for that), but this is the key distinction. In traditional 401(k) plans, employer contributions are allowed but not required—and you face the added burden of annual testing.

As with all things in life, Safe Harbor plans come with tradeoffs. Matching your employees’ contributions—or contributing regardless of whether they do through what’s called a nonelective contribution—is great for your employees' financial wellbeing, but it could also increase your overall employee budget by 3% or more depending on the size of your contribution.

Most 401(k) plans established on or after December 29, 2022 must include automatic enrollment, at a default rate that starts at 3% and rises each year (but this requirement only takes effect for plan years beginning after December 31, 2024).

If your new plan requires auto-enrollment anyway, a QACA (qualified automatic contribution arrangement) is worth a look. It's a Safe Harbor plan built around automatic enrollment, with a slightly lower match ceiling and the option to require up to two years of service before contributions fully vest, rather than vesting them immediately. For a new plan, that's often cheaper and lower-risk than a standard Safe Harbor design.

Federal law requires annual nondiscrimination tests, which help ensure 401(k) plans benefit all employees—not just business owners or highly compensated employees (HCEs). Because the federal government provides significant tax perks through 401(k) plans, it wants to make sure these benefits don’t more heavily favor high earners.

The three main nondiscrimination tests are:

• Actual deferral percentage (ADP) test: Compares the average salary deferrals of HCEs to those of non-highly compensated employees (NHCEs).
• Actual contribution percentage (ACP) test: Compares the average employer matching contributions received by HCEs and NHCEs.
• Top-heavy test: Evaluates whether a plan is top-heavy, that is, if the total value of the plan accounts of “key employees” is more than 60% of the value of all plan assets. The IRS defines a key employee as an officer making more than $235,000 (indexed), an owner of more than 5% of the business, or an owner of more than 1% of the business who made more than $150,000 during the plan year. If your plan lets employees in before age 21 or before a year of service, those employees can be tested separately for top-heavy purposes. (These dollar thresholds change annually—confirm current-year figures before publishing.)

In practice, it’s easier for large companies to pass the tests because they have a lot of employees at many different income levels contributing to the plan. If, on the other hand, even just a few HCEs at a small-to-midsize business contribute a lot to the plan, but the lower earners don’t, there’s a chance the 401(k) plan will not pass nondiscrimination testing.

If your plan fails nondiscrimination testing, you’ll need to fix the imbalance by either returning a portion of the contributions made by your highly compensated employees or by increasing the contributions of your non-highly compensated employees. If you have to refund contributions, affected employees may fall behind on their retirement savings—and that money may be subject to state and federal taxes. If you don’t correct the issue in a timely manner, there could also be a 10% penalty fee and other serious consequences.

Failing these tests, in other words, can be a real pain in the pocketbook.

Every company is different, but here’s a list of employer characteristics that tend to align best with the plan type.

Your staff count is in the dozens, not hundreds.

Not all small businesses are created equal. In general, however, the smaller your staff count, the more likely it is that the 401(k) contributions of high earners could outweigh those of their lower-compensated peers. If that happens under a traditional 401(k) plan, you’re at a higher risk of failing nondiscrimination testing.

Your staff includes a lot of part-time or seasonal employees who don't meet the long-term part-time threshold.

Part-time and seasonal workers are often eligible for your 401(k) plan but rarely contribute much, which can pull down your testing averages. But if they're eligible only because of the long-term part-time (LTPT) rules—500+ hours in two consecutive years—you can leave them out of nondiscrimination testing and out of your employer contributions, without putting your plan's top-heavy exemption at risk.

That means a large part-time workforce isn't, by itself, a strong reason to choose Safe Harbor. Just know that identifying who qualifies means tracking hours year over year, and that anyone your regular eligibility rules already cover counts in testing like any other employee.

Your company has previously failed ADP or ACP compliance tests.

This one’s a no-brainer. If traditional 401(k) plans have given you testing fits in recent years, switching to a Safe Harbor plan could help avoid these costly tripups.

Your company’s previous plans have been deemed “top-heavy.”

Even if you've passed ADP and ACP testing, a past top-heavy result may repeat, and Safe Harbor plans are generally exempt from top-heavy requirements.

Plans can now test employees who are under 21 or in their first year of service separately from everyone else. If those employees were part of why your plan came up top-heavy, running the test that way may change the result—or at least narrow the group owed a minimum contribution. It’s worth confirming with your provider before assuming the problem repeats.

Your company has consistent and adequate cash flow.

Safe Harbor 401(k) plans offer employees a pretty sweet deal. The company kicks in a minimum of 3-4% of their salaries, either contingent on a matching contribution or not (see: nonelective). That money vests immediately, too, which means employees can quit tomorrow and keep it. This commitment to your workforce’s retirement savings is the key cost consideration of Safe Harbor plans.

If you're starting a new plan, though, tax credits can absorb much of that early cost. Small employers may be able to claim up to $5,000 a year for three years toward startup and administrative costs, plus a credit of up to $1,000 per employee on the contributions themselves. The contribution credit covers the full amount in the first two years, then steps down each year until it phases out.

Here's the catch: The credits are temporary and the contribution isn't. Once they run out, you're carrying the full 3-4% on your own, which is why we don’t recommend Safe Harbor for companies with unpredictable cash flow year over year. A traditional plan keeps employer contributions optional, so you can match when it makes sense and scale back when it doesn't.

You’d rather avoid administrative burdens.

Take it from us: Even successful compliance takes work. And failures can mean uncomfortable conversations with impacted employees, who’ll need to know why their contributions are being returned and may not be able to save as much as they planned.

Not every misstep is costly, though. Certain errors, including automatic enrollment and escalation mistakes, can be self-corrected without penalty, generally if you fix them within 9.5 months after the end of the plan year in which the mistake occurred. If you'd rather not manage the risk at all, Safe Harbor is worth considering.

If you’re strongly considering setting up a Safe Harbor plan or adding a Safe Harbor contribution to your existing plan, here are a few key deadlines you need to know:

Starting a new plan

For calendar year plans, October 1 is the final deadline for starting a new Safe Harbor 401(k) plan. But don’t cut it too close—you’re required to notify your employees 30 days before the plan starts—and you’ll likely need to talk to your plan provider before that. If we’re fortunate enough to serve in that role for you, that means we’ll need to sign a service agreement by August 1.

Adding Safe Harbor to an existing plan

If you want to add a Safe Harbor match provision to your current plan, you can include a plan amendment that goes into effect January 1 so long as employees receive notice at least 30 days prior. At Betterment, the deadline for you to request this amendment is October 30.

Communicating with employees

Every year, eligible employees need to be notified about their rights and obligations under your Safe Harbor plan (except for those with nonelective contributions, as noted above). The IRS requires notice be given between 30-90 days before the beginning of the plan year.

Whichever plan type fits your company, choosing the right provider makes the setup and ongoing administration far easier. An experienced plan provider like Betterment at Work can bring a lot to the table:

• Flexible plan features
• Dedicated service and expert operational support
• Employee support team
• Transparent pricing

Ready to talk to someone on our team? Reach out today.