Why it matters: the ADP test
Without a safe harbor, a 401(k) plan must pass the Actual Deferral Percentage (ADP) test each year. It compares the average deferral rate of owners and highly compensated employees with that of everyone else.
Owners often want to defer the maximum while employees defer less, and the test allows only a small gap. If the plan fails, owners and highly compensated employees can receive refunds, which are taxable in the year they’re paid.
How it works
- Goes to non-highly compensated employees who are at least 21 with one year of service, and can also go to owners and highly compensated employees
- 100% vested immediately, except the automatic enrollment match, which can use a two-year vesting schedule
- Set out in the plan document and in an annual notice to employees
- Generally must be in place for a full 12-month plan year
The three main designs
Nonelective
Formula3% of pay to all eligible employees, whether or not they defer
VestingImmediate
Best forPlans adding a cross-tested profit sharing contribution, since the 3% counts toward testing
Basic match
Formula100% of the first 3% deferred, plus 50% of the next 2% (up to 4%). Enhanced versions match up to 4%, 5% or 6%
VestingImmediate
Best forPlans that want to reward employees who save
Automatic enrollment match
Formula100% of the first 1% deferred, plus 50% of the next 5% (up to 3.5%)
VestingUp to 2 years
Best forPlans using automatic enrollment
Removing a safe harbor mid-year
A safe harbor can be removed by plan amendment, but only mid-year if the business is acquired, the business is operating at an economic loss under Internal Revenue Code 412(c)(7)(A), or the annual notice said the contribution could be reduced or suspended.
Removal requires 30 days’ notice to participants and a plan amendment, and contributions must be funded through the date of removal. Unless the business was acquired, the plan must then pass the ADP test for that year.