Best Practices in HR

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Aaron Carr
  March 13, 2018

Safe Harbor 401(k) Plan: What it is, Contributions & Matching Rules

A Safe Harbor 401(k) is a retirement plan allowing employers and high-earners to shelter income that would be considered “discriminatory” against employees in a standard retirement plan. Employers and high-earning employees can shelter $55,000-$61,000 per year from income tax without falling out of compliance by providing matching contributions to employees.

Safe Harbor 401(k) vs. Traditional 401(k)

A Safe Harbor 401(k) plan is a type of retirement plan designed exclusively for businesses that might run into compliance issues with more traditional 401(k) plans. With a traditional 401(k), plan assets have to remain balanced between high-earning employees and non-high-earning employees and is tested frequently to ensure this ratio is met.

If a traditional 401(k) plan is seen to be more beneficial for business owners and/or employees earning more than $120,000 per year, the IRS can require that retirement funds are returned to high-earners until the plan is put back in balance. This can result in a higher income tax burden and lower retirement savings for business owners and high-earning employees.

Luckily, Safe Harbor 401(k) plans aren’t subject to this ratio testing (known as “non-discrimination testing”), allowing high-earning employees and owners defer larger sums of income without fear that the plan will be thrown out of balance and deferred income returned. To qualify, however, business owners are required to participate in elective or nonelective employee matching.

Who a Safe Harbor 401(k) Plan is Right For

Businesses using Safe Harbor 401(k) plans are often small- to medium-sized companies with strong sales, little need to reinvest profits, and at least 8-12 employees. Employers who have previously failed non-discrimination testing by the IRS or their plan administrator – or think they may fail in the future – should consider a 401(k) Safe Harbor plan.

  • Some typical employers who find a Safe Harbor 401(k) Plan appropriate include:
  • Entrepreneurs with few employees and high profitability
  • Businesses where more than half of plan assets belong to highly-compensated employees or owners
  • Companies with owners and high-earners that make up more than 10%-15% of the workforce
  • Medium-sized companies with several high-earners who want to shelter income but struggle with turnover among non-highly compensated employees
  • Small- or medium-sized businesses that are nearing a management transition and want to reward high-earners who helped build the company

Business owners who want to set up a 401(k) Safe Harbor can do so from scratch or by converting an existing plan to meet Safe Harbor requirements. More information on setting up a Safe Harbor 401(k) can be found in the How to Set up a Safe Harbor 401(k) Plan in 5 Steps section below.

Identifying Safe Harbor 401(k) Plan Providers

401(k) plan providers come in all shapes and sizes. They can aid in plan design, adoption, and administration, update the plan when necessary, and submit necessary filings to regulators. Some providers conduct compliance testing, help select investment options within the plan, coordinate payroll, and work with management to make matching or profit-sharing contributions.

4 of the top Safe Harbor 401(k) plan providers include:

Charles Schwab

Known primarily as a wealth management firm, Schwab has banking and institutional arms that provide 401(k) solutions for businesses. These services can be cost-prohibitive for smaller plans but include plan design, implementation, and administration in addition to advising on investment options and selections.


Fidelity is a multinational financial services company that’s known mostly for its brokerage services, proprietary mutual funds, and wealth management services. Like Schwab, Fidelity also provides employee benefits solutions and can assist on plan design, administration, and advising.

Price Waterhouse Cooper (“PWC”)

PWC is one of the largest accounting firms in the world and also a provider of retirement benefit services. Though it’s primary services revolve around plan administration and auditing (compliance testing), PWC also provides advice on investment strategy, investment selection, etc.

Human Interest

Human Interest is an online plan provider with the mission to help companies of all sizes offer retirement plans to their employees. While they’re newer to the space, Human Interest is an alternative to the more traditional providers we mention above and might be a great fit for smaller companies looking for a fast and agile provider.

How to Set up a Safe Harbor 401(k) Plan in 5 Steps

Establishing a Safe Harbor 401(k) plan is nearly identical to any other 401(k). The differences are in matching, disclosures, and other obligations that are outlined in plan documents and must be followed precisely in plan administration. Luckily, most plan providers will take care of these 5 steps for you.

safe harbor 401k

The 5 steps for implementing a Safe Harbor 401(k) plan include:

1. Draft and Adopt a Plan Document

Every 401(k) plan is governed by a plan document, which meets specific guidelines. The plan document will outline the rules and limitations on employee deferrals, employer matching, employee eligibility and enrollment, vesting and other items.

It’s not unusual for small business owners to hire professionals to help set up a plan. This is because most providers will have templates prepared that make this step much easier.

2. Structure a Trust to Hold Plan Assets

One integral aspect of retirement accounts in the United States that’s overlooked is that assets held in tax-deferred accounts are required to be held by a trust for the benefit of plan participants. In other words, employees can’t hold the money themselves.

In setting up a 401(k) plan, one of the most important steps is the formation of the trust that will hold participants’ accounts on their behalf. Every trust must have a trustee to serve as the ultimate overseer of plan’s assets and operations. Trustees can include managers of the company or providers to the plan, and are as important as forming the trust itself. Providers will typically help you with structuring this trust.

3. Put in Place a Recordkeeping System for the Plan

While recordkeeping is often handled seamlessly by a plan administrator or other provider, it is of the utmost importance for ensuring the financial integrity of the plan. All deferrals, matching contributions, gains and losses must be recorded, as must all plan expenses and disbursements. Plan providers will usually do this automatically.

4. Make Appropriate Disclosures to Eligible Employees

Once a 401(k) plan has been implemented, disclosures must be provided to those employees eligible to participate. These disclosures include the rules and restrictions of the plan, the advantages of tax-deferred savings, investment options, and other items.

Importantly for employers structuring a 401(k) Safe Harbor Plan, these disclosures have strict deadlines and need to include details on the employer contribution structure to be used. Plan providers will usually have templatized disclosures that you can use when telling your employees.

5. Begin Making Mandatory Contributions

Once established, the plan must follow plan documents and requirements from the IRS and Department of Labor, which govern retirement plans under ERISA. Plan documents set out the types and timing of employer contributions to employee accounts. Plan providers will typically set this up for you and do it automatically.

Safe Harbor 401(k) Plan Contribution Limits 2018

Safe Harbor plans allow for up to 100% of an employee’s income or $55,000-$61,000 (including catch-ups) in total contributions, whichever is less. Contributions are comprised of employee deferrals, employer matching and profit-sharing. For a 401(k) plan to qualify for Safe Harbor, employers are required to make mandatory contributions to employee accounts.

The three types of contributions to 401(k) plans and their respective 2018 limits are:

  • Employee Deferrals – The maximum total employee deferrals for 2018 is $18,500.
  • Employer Matching – Matching formulas are set out in plan documents, and are also limited to $18,500 for 2018.
  • Profit-Sharing Component (Discretionary) – Employers can elect to make profit-sharing contributions to a Safe Harbor 401(k) plan. Funds are distributed among employees according to the plan documents and limited to $18,000/each.

Safe Harbor plans must also make one of the following mandatory employee contributions:

Safe Harbor Elective Contributions

The first option for structuring employer contributions to qualify a 401(k) plan for Safe Harbor is through generous matching of employee deferrals. To qualify, a plan must use a matching formula which will effectively match employee deferrals of at least 4% of their compensation. To accomplish this, there are two formulas that are commonly used.

Employers use one of the following matching formulas:

  1. Basic Matching – Match 100% of their employees first 3% of deferrals, plus 50% of additional deferrals up to 5% or more
  2. Enhanced Matching – Simply match 100% of employee deferrals up to at least 4%.

These contributions are considered elective because they are based entirely on voluntary employee participation in the plan and deferrals that they elect to take. This encourages voluntary participation in the plan because employees don’t receive any matching contributions unless they participate with deferrals.

Safe Harbor Nonelective Contributions

The second way that employers can structure a 401(k) Safe Harbor is through the use of nonelective contributions. Under this option, employers make contributions into employees’ 401(k) accounts totaling at least 3% of each employee’s compensation. These contributions are made whether an employee defers part of their compensation or not – thus, they are nonelective.

This option is relatively less popular, as it provides little incentive for employees to participate with their own savings. Instead, each employee is given a 401(k) contribution equal to at least 3% of their overall compensation, regardless of whether or how much they elect to contribute themselves. Nonelective contributions can represent a generous reward for employees and prove far more economical than similar requirements in alternative plans like SEP IRAs.

Safe Harbor Mandatory Matching Contributions

Employee Deferral
(% of W-2 income)
Basic Match
Enhanced Match
Nonelective contributions
3% of W-2 income, regardless of whether an employee defers income

Andrew Almeida Almeida Investment Management safe harbor 401k

“What will also be important for the sponsor to consider is if the employer will be implementing a profit sharing plan in addition to the traditional 401k. If so, a non-elective contribution safe harbor option could have its benefits. That is because the profit sharing plan will have to also pass its own compliance testing.” -Andrew Almeida, CFA, CFP, Founder, Almeida Investment Management

Safe Harbor 401(k) Plan Costs

Costs for 401(k) plans are paid directly by company owners, from plan assets, or from mutual fund fees within the plan. Fees can range from 0.25% to over 4% and include such costs as administration, custodian, advisory fees and more. Total costs between 1.25%-2% of plan assets is usually a good target.

Depending on the providers used, the types of fees to be paid may include:

  • Plan administration fee (0.25%-2% annually) This fee is for administering the plan, overseeing deposits and disbursements, filing the annual Form 5500, compliance testing, and other items. The fee is often structured on a per-plan rate plus a per-participant charge.
  • Custodian fee (0.25% of plan assets) A financial institution typically serves as a custodian because assets need to be held in trust for plan participants. The fee may be either fixed or based on plan assets but is no more than 0.25% of total plan assets. It can also be included in other fees or credited against investment fees.
  • Advisor fee (1% of plan assets) – Some plan sponsors choose to engage a financial advisor to help steer the plan and advise plan participants. Advisors usually base their fee on plan assets and start at a fraction of a percent per year. Fees can be over 1% of plan assets per year but, again, are sometimes partially paid from investment fees.
  • Investment fees (0.25% to over 2% of plan assets) – The specific investment options (usually mutual funds) used in a 401(k) plan charge their own fees which are automatically deducted as part of their expense ratios. Depending on the structure of a plan and providers used, these fees are sometimes used to help offset other costs.
  • Recordkeeping (0.15% and 1% of plan assets) – Plan recordkeeping is often included with plan administration services and covers the basic bookkeeping for a plan. All deferrals, disbursements, employer contributions and expenses are tracked and recorded for proper reporting. Fees for this service have historically been fixed-cost, but recently more sponsors have been shifting to asset-based fees between 0.15% and 1%.

For 401(k) Safe Harbor plans, the biggest differences in cost are not due to plan administration, custodial fees, investment selection or advisory services, but to escalated employer contributions that must be paid into employees’ accounts.

Employers who use a Safe Harbor 401(k) can also potentially see higher costs over time from employee turnover, due to the immediate vesting required for employer contributions. The hope is that higher matching provided in a Safe Harbor 401(k) induces employees to stay. Further, any increase in costs is also offset by increased benefits for company owners and high earners, who can shelter far larger portions of their incomes from taxes.

John Hughes Hawley Troxell safe harbor 401k

“There are costs associated with ensuring that there is compliance with the additional detail, such as making sure that the required “safe harbor notice” includes all of content that is mandated by the regulations and ensuring that the notice is properly delivered.” -John Hughes, Of Counsel, Hawley Troxell

Warren Ward WWA Planning and Investments safe harbor 401k

“Although they make it somewhat harder to maximize owner contributions, in our experience they are almost always less expensive than traditional plans. Since there’s no testing required, third-party administrator fees are almost always lower.” -Warren Ward, CFP, Founder, WWA Planning and Investments

How a Safe Harbor 401(k) Plan Works

Safe Harbor 401(k) plans are similar to any other 401(k) plan, including early withdrawal penalties, contribution limits, and distributions. What makes a Safe Harbor plan unique, however, is that business owners and high-earning employees can contribute larger amounts of annual income without compliance issues. This is because Safe Harbor plans aren’t subject to “non-discrimination testing.”

Non-discrimination testing is a tool used by the IRS in order to determine the degree to which a plan’s assets or contributions are concentrated among company owners and highly-compensated employees (HCEs). Plans are considered “discriminatory” towards non-highly-compensated employees (NHCEs) if owners/HCEs have deferrals or contributions that more than double NHCEs, or if more than 60% of plan assets are concentrated towards key employees.

For reference, owners and highly-compensated employees are defined as:

  • Owners with a 5%+ stake in the company
  • Any employee making more than $120,000 over the preceding year

If a plan fails non-discriminatory testing, it must be brought back into compliance with “corrective distributions,” which require the return of salary deferrals to company owners and high-earners as taxable income, thus increasing income taxes owed and decreasing the retirement funds in their 401(k). Safe Harbor 401(k) plans are exempt from testing, which alleviates potential restrictions for owners and HCEs.

In order to qualify as a Safe Harbor 401(k), employers must commit to either elective (matching) or nonelective contributions for employees that meet specific IRS requirements. If employee deferrals, employer match, and profit sharing are maximized, annual contribution limits for 2018 can total $55,000-$61,000 without fear of corrective distributions.

Employers must choose one of the following two types of contributions:

  • Elective contributions – An employer commits to match employee deferrals of at least 4% of employee compensation.
  • Nonelective contributions – An employer makes contributions directly into employee accounts equal to at least 3% of employee compensation, even if employees don’t make any deferrals.

Non-Discrimination Testing for Safe Harbor Plans

To identify 401(k) plans that discriminate against non-highly compensated employees (NHCEs), the IRS imposes three ratio-based tests annually to measure the concentration of plan assets and contributions. If a 401(k) plan fails any of the tests, the plan must be brought back into compliance retroactively or during the succeeding 12 months, depending on which test is failed.

Correcting a non-compliant plan may require nonelective contributions for NHCEs or corrective distributions among owners and highly-compensated employees (HCEs) to bring the plan back in balance. A study of 401(k) plan data from 2013 revealed that more 54,000 plans – or about 10% of plans then in existence – had to make corrective distributions because they failed non-discrimination testing. Luckily, Safe Harbor 401(k) plans aren’t subject to this testing.

The 3 types of non-discriminatory testing include:

1. ADP Test

The ADP Test first involves calculating the average annual deferral rates of HCEs – the percentage of their income that they defer and deposit in their 401(k) account. The same is then done for NHCEs. If the average annual deferral rate for NHCE is 2% or less, the average rate for HCE’s can’t be more than double the average deferral rate for NHCEs.

If the average deferral rate for non-highly-compensated employees (NHCEs) is between 2% and 8%, the rate for highly-compensated employees (HCEs) can’t be more than 2% higher than the rate for NHCEs. If the average annual deferral rate for NHCEs exceeds 8%, then the rate for HCEs can’t be more than 25% higher than the NHCE average. Plans that fail this test must make corrective distributions until the deferral ratio falls into compliance.

2. ACP Test

The ACP Test is almost the same as the ADP Test, but instead of using employees’ deferral rates, it relies on their contribution rates, defined as their deferred compensation plus any employer matching. For example, if the average annual contribution rate for NHCE is 2% or less, the average rate for HCE’s can’t be more than double the average rate for NHCEs. If the average annual contribution rate for NHCEs exceeds 8%, the rate for HCEs can’t be more than 25% greater than the NHCE average.

Also like the ADP test, if a plan fails the ACP test, corrective distributions have to be made until the ratio of contributions between HCEs and NHCEs falls back into compliance.

3. Top-Heavy Test

The Top-Heavy Test is done by totaling plan assets held for key employees. A key employee is anyone who makes $170,000 or more per year, owns 5% of the company, is immediate family of someone who owns 5%, or anyone who owns more than 1% of the company and earns more than $150,000 per year. The percent of plan assets held by individuals who qualify as key employees cannot exceed 60% of total plan assets.

If so, corrective distributions are required to put the ratio of plan assets back in balance.

Nick Ferdon Captain401 safe harbor 401k

“Most 401(k) providers are traditionally very reactive. They don’t tell you that you’re about to be out of compliance. They just tell you at the end of the year when it’s already too late. Business owners need to be careful to conduct testing continually or work with a provider who can alert them that their plan is heading toward non-compliance.” -Nick Ferdon, Sales Manager, Human Interest

Safe Harbor 401(k) Plan Matching Rules

In order for a 401(k) to qualify for Safe Harbor, employers must not only structure qualifying contribution programs but also follow strict guidelines that govern the plan’s operations and administration. Failure to follow any one of these rules can disqualify a Safe Harbor plan or lead to penalties for plan sponsors.

The 4 primary plan matching rules include:

1. Provide Employees with Disclosures

Before implementing a plan, employers must provide employees will certain disclosures that include the contribution method (elective or nonelective) to be used by the plan and the matching formula, if applicable.

2. Adhere to Filing Deadlines for Plan Documents and Disclosures

The IRS provides detailed deadlines for preparation and adoption of plan documents, annual filings, and employee disclosures.

3. Follow Contribution Amounts and Procedures in Plan Document

Failure to comply with contribution requirements set out in plan documents can lead to stiff penalties and/or corrective actions.

4. Immediately Vest Employer Contributions for all Participants

Employee deferrals always vest immediately, but employers often structure plans with delayed vesting of matching contributions. This creates a golden handcuff that ties an employee to the company since they would forfeit part of their employer’s contributions by leaving early.

Whether elective or nonelective contributions are used, employer contributions must be vested immediately in a Safe Harbor 401(k) plan with two exceptions: (1) the profit-sharing component of employer contributions and (2) for employers who utilize a Qualified Automatic Contribution Arrangement.

Qualified Automatic Contribution Arrangement (QACA)

A QACA is a subtype of Safe Harbor 401(k) plans that’s relatively new. Matching requirements are similar, although formulas differ. The biggest difference with a QACA is that employees who don’t enroll in the company’s 401(k), but also don’t take steps to opt-out, must be automatically enrolled on a date specified in plan documents.

The highlights for QACAs include:

  • Automatic enrollment for any employee who doesn’t opt out at predetermined deferral and matching rates
  • Employers must fully match the first 1% of employee deferrals plus 50% of deferrals between 1% and 6%, with an effective match rate of at least 3.5%, or
  • Employers make non-elective contributions to employee accounts equalling at least 3% of each employee’s total compensation
  • Contributions are not required to be immediately vested, but can instead be subject to a 2-year schedule from the IRS

Alternatives to a Safe Harbor 401(k)

A 401(k) Safe Harbor isn’t appropriate for all small businesses, so business owners should consider simple, cost-efficient alternatives that are more familiar and can be much easier to setup and administer. These include several types of qualified IRAs as well as traditional 401(k) plans that do not qualify for Safe Harbor status.

The 4 best alternatives to a Safe Harbor 401(k) plan include:

1. Traditional IRA

The Traditional IRA is the simplest of all qualified retirement accounts. Accounts are easy to create, cost almost nothing to administer and permit account-holders incredible flexibility in selecting investments. These accounts can be created from scratch or used for rolling over account balances from other types of qualified plans to achieve greater account flexibility or mobility.

The downsides are twofold. First, Traditional IRAs can’t be utilized by anyone who is eligible for a qualified retirement plan through their employer. Second, the IRS limits tax-qualified contributions to Traditional IRAs to just $5,500 per year ($6,500 for participants over age 50 who want to make catch-up contributions).

Traditional IRAs are often a good choice for independent consultants and sole practitioners who have not yet achieved a high degree of profitability, as well as employees of small businesses that have not yet set up company-sponsored retirement plans.


A SIMPLE IRA (Savings Incentive Match Plan for Employees), sometimes called a “poor man’s 401(k),” is another straightforward alternative to more expensive employer retirement plans. In the case of SIMPLE IRAs, plans must be set up by an employer – just like a 401(k) – but are relatively easier to establish and cheaper to administer.

As in 401(k) plans, employees eligible for SIMPLE IRAs make elected deferrals that are matched by employers according to predetermined formulas outlined in plan documents. Contribution limits are higher than in Traditional IRAs, with employees able to defer up to $12,500 ($15,500 with catch-up contributions) for 2018. Employers can match employee deferrals up to 3% but must match at least 1% for no fewer than 2 of the preceding 5 years.


At the far end of the retirement account spectrum are SEP IRAs, which are set up and administered by an employer and prohibit employee deferrals. Instead, employers make all contributions, which must be proportional for all employees (including themselves) based on individual compensation and limited to the lesser of $55,000 or 25% of pre-tax income.

SEP IRAs are perhaps the most flexible IRAs available for employers, but also among the most expensive – not because of administrative costs, which are virtually zero, but because company owners are responsible for all contributions to employee accounts. These plans can be extremely advantageous for very small businesses (1-5 employees) with high levels of profitability.

4. Traditional 401(k) Plans

Traditional 401(k)s are almost identical to Safe Harbor Plans, except they aren’t subject to the same employer contribution requirements. Instead, these plans undergo annual nondiscrimination testing from which Safe Harbor Plans are exempt and typically restrict the amounts that company owners and HCEs can defer due to low NHCE participation or top-heavy account balances.

Like Safe Harbor Plans, Traditional 401(k) Plans require plan documents to be structured and adopted, recordkeeping systems to be put in place, a trust to be formed and administered to hold plan assets, and timely disclosures to be made to eligible employees. Administration fees, custodian fees, annual filing charges, and other costs are typically involved with setup and maintenance of a plan.

How Retirement Accounts Stack Up: A Quick Comparison

Type of Plan
Employee Deferral Limit
Deferral Limit with Catch-Up
Safe Harbor 401(k)
Traditional IRA
SEP IRA or solo 401(k)
Traditional 401(k)

*Contributions must be from employers, rather than through employee deferrals.

Bottom Line

Many options exist for employers and employees to save for retirement and shelter income from taxes each year. Safe Harbor 401(k) plans offer tremendous advantages for owners and highly-compensated employees (HCEs) to shelter sizeable amounts of income each year. This can happen because of generous contribution programs.