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Safe Harbor 401(k) – The Best Small Business 401(k) Plan

Solo 401(k)

Employers start a 401(k) plan for many reasons. A well-designed 401(k) plan can help attract and keep talented employees and allows participants to decide how much to contribute to their accounts. In addition, a 401(k) plan offers employers a tax deduction for employee contributions. This can also benefit a mix of rank-and-file employees and owners/managers.

Key Points
  • Every small business should have a retirement plan
  • Safe Harbor 401(k) plans do not require plan testing
  • Owners and highly compensated employees can maximize contributions easier

Any U.S. business can establish a 401(k) plan.  The business can be a solo proprietorship, LLC, corporation, partnership, or any other legal entity. The biggest advantage of saving through a 401(k) plan is that contributions are elective and can create a tax deduction. In addition, all income and gains from plan assets grow without tax.  This is known as tax-deferral (or tax-free growth in the case of a Roth 401(k) plan contribution).

The Most Common 401(k) Plans

Safe Harbor

Safe Harbor 401(k) Plans are very popular with business owners and plan participants alike. 

A Safe Harbor 401(k) is a way to structure a plan that automatically passes the complex ERISA non-discrimination test, which could limit the amount the owners and highly compensated employees can contribute to the plan. A safe harbor plan essentially requires the employer must make contributions to each employee’s plan — the same percentage of salary for everyone. However, it allows the business owner(s) and highly compensated employees to max out their plan contributions.

Advantage: Provides a guarantee to the business owner(s) or highly compensated employees that they will be able to max out their plan contributions.  Plus, safe harbor contributions are tax-deductible.

Disadvantage: Must provide at least a three percent safe harbor contribution annually based on the employee’s salary.

Traditional 401(k) Plan

A 401(k) plan that is not covered by the safe harbor rules will need to comply with a number of complex ERISA tests in order to allow the business owner(s) and highly compensated employees to max out their contributions. In a traditional 401(k) plan, the business owner(s) have the option of making contributions on behalf of all participants, making matching contributions based on employees’ elective deferrals, or both.

Advantage: Not required to make safe harbor contributions of at least three percent of each eligible employees’ salary.

Disadvantage: Subject to complex plan testing and does not provide the business owner(s) or highly compensated employees with the guarantee that they will be able to max out their contributions.

Profit Sharing Plan

Retirement benefits are based on the amount in the participant’s individual account balance at retirement. The account balance depends on contributions made and earnings credited through the years.  The maximum employer profit sharing contribution is 25% of compensation or 20% if self-employed or single member LLC.

Advantage: Simple to operate and employer has control over contributions.

Disadvantage: No employee deferrals and limits contributions to a percentage of compensation.  Also – profit sharing contributions must be made to all eligible employees.

The Safe Harbor 401(k) Plan – Most Popular Choice for Small Business Owners

Safe Harbor 401(k) Plans are very popular with business owners and plan participants alike.  The Safe Harbor 401(k) provisions have some very big benefits, with a few drawbacks. 

Beginning in 1999, the Safe Harbor rules were designed to make 401(k) plans more popular with small business owners.  If the rules are followed, a Safe Harbor 401(k) Plan is allowed a free pass on the Actual Deferral Percentage (ADP) test, the Actual Contribution Percentage (ACP) test and the Top Heavy minimum contributions.

A Safe Harbor 401(k) is a way to structure a plan that automatically passes the non-discrimination test or avoid it altogether. This test could limit the amount the owners or highly compensated employees can contribute to the plan. Under a safe harbor plan, one can match each eligible employees contribution, dollar for dollar, up to three percent of the employees compensation. Plus, 50 cents on the dollar for the employee’s contribution that exceeds three percent, but not five percent. Alternatively, one can make a non-elective contribution equal to three percent of compensation to each eligible employees’ account.

The main advantage of an employer using a Safe Harbor 401(k) Plan is that the business owner can gain the right to make maximum employee deferrals without having to satisfy the complex ADP & ACP ERISA plan tests.  The downside is that the employer will likely be required to have at least a minimum three percent tax deductible contribution to all eligible employees, based on their compensation.

Safe Harbor & Alternative Assets

The plan documents determine whether a plan participant is permitted to invest plan funds in alternative assets, such as real estate.  The majority of all 401(k) plans do not allow their plan participants to invest in alternative assets.  The main reason behind this is the business owner is typically acting as the plan trustee and does not want to be involved in the facilitation or approval of an employee’s investment.  It is a lot easier to have a registered financial advisor select the plan investments and assist the employees with investment decisions.  However, there are a growing number of small businesses that will allow their employees to have alternative asset investment options.

IRA Financial is one of the few 401(k) plan providers in the country that has the expertise and experience to allow clients to invest their 401(k) plan assets in traditional investments, such as mutual funds and ETFs, but also alternative assets, such as real estate or private investment funds.

Safe Harbor & ROBS

The Rollover Business Start-Up Solution (ROBS) is the only legal way one can use his or her retirement funds to start a business they will be personally involved with. As part of the ROBS solution, the business must be operated though a C Corporation and a 401(k) plan must be used to fund the C Corporation by the purchase of corporate stock or qualifying employer securities.  Accordingly, in order to establish a ROBS solution, the C Corporation will need to have adopted a 401(k) plan.

The Safe Harbor 401(k) plan is the most popular 401(k) plan established by ROBS investors.  Why?  Because it is easy to operate and administer, and allows the business owner to max out their plan contributions without having to worry about failing the very complex ERISA plan tests.  By establishing a Safe Harbor 401(k) plan, the business owner can save for retirement, generate tax deductions, as well as help attract and keep talented employees.

Get in Touch

To learn more about the benefits of establishing a Safe Harbor 401(k) plan, please contact one of our 401(k) plan specialists at 800-472-0646. Be sure to check out our YouTube page for tons of videos about retirement planning and investing!

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