The Small Business 401(k) Plan: A Safe-Harbor

Over the last few years, many small businesses owners have implemented SIMPLE IRA plans because they didn't want to pay the various expenses associated with traditional 401(k) plan's reporting and non-discrimination test requirements. But, there is another alternative that allows for greater tax-deferred savings than the SIMPLE IRA and still avoids the bulk of the administrative expenses of the traditional 401(k). This alternative is the Safe Harbor 401(k) ('SH') plan. The SH plan combines the best features of the SIMPLE IRA plan and the traditional 401(k) plan. This article explores some of the details of the SH plan, along with some attractive planning strategies.

Advantages of Safe Harbor 401(k) plans.
The primary reason any small business considers the SH plan is a desire to avoid the expensive non-discrimination tests and IRS filing requirements associated with the traditional 401(k) plan. Although the SIMPLE IRA plan eliminates these expenses, there is a trade off. Participants in a SIMPLE IRA plan are only permitted to salary defer up to $10,000, for 2006, with an additional $2,500 catch-up is available to participants age 50 and over. Traditional 401(k) participants, on the other hand, are permitted to defer up to $15,000, for 2006, with an additional $5,000 catch-up available to participants age 50 and over. Additionally, a SIMPLE IRA plan does not permit the small business to make a discretionary profit sharing contribution.

The Safe Harbor options.
Small businesses establishing the SH plan have two options for making contributions to employee accounts. Both of these options require the contributions to be fully vested.

• Matching contribution: The employer matches 100% of non-highly compensated employees (NHCE) salary deferral up to 3% of the employee's compensation, plus 50% of the NHCE's deferral between 3 to 5% of compensation. This translates into a 4% matching contribution for employees deferring 5% of compensation or more. Employees making no deferral would receive no match.
• Non-elective contribution: The business contributes 3% of pay to all eligible NHCEs whether or not they elect to make a salary deferral contribution.

The matching contribution option.
Most small business owners who make the decision to implement a SH plan are likely to choose the matching option. It is very likely that the SIMPLE IRA plan will also have been considered, and the value the higher deferral limit ($15,000 for 2006), plus the future tax-deferred growth on the additional contribution, outweighed any additional administrative expense. The SH plan is usually a good fit where a low participation, or salary deferral rate, by the NHCEs causes the traditional 401(k) plan's ADP test to severely limit salary deferral contributions by the business owners and other highly compensated employees.

The SH match does not cost the employer much, because only those who make salary deferrals will receive any of the company match. In other words, employees must 'pay to play.' Additionally, the SH plan's match satisfies the 401(k) 'top-heavy' minimum requirement. All 401(k) plans are considered top-heavy when more than 60% of the plan assets are in the accounts of the key employees. The majority od small business 401(k) plans are top-heavy by the end of the first plan year, especially where a high percentage of employees are family members or key employees.

The non-elective option.
This option works just like a profit sharing contribution - any employee who meets the SH plan's eligibility requirements receives a 3% of pay contribution. As with the match option, this 3% non-elective option will also satisfy the top-heavy requirement. The non-elective option does provide an advantage over the matching option. Non-elective contributions may also be applied toward satisfying another type of non-discrimination test: the plan coverage tests. This is significant for small businesses that may be able to take advantage of a cross-tested, or comparability, allocation formula as discussed below.

Combining the Safe Harbor plan with a cross-tested plan.
A cross-tested plan contains an allocation formula that favors a certain class of employees if, collectively, that group is older than the non-favored group. The plan could define the business owners as one group and the remaining work force as another group. If the average age of the owners is 48, and the average age of the employees is 35, the cross-tested rules allocate more of the dollars going into the plan into the accounts of the business owners. The cross-tested allocation formula could not provide for larger proportionate contributions to those closer to retirement if there were no age difference between the two groups.

Summary.
When the features of the SIMPLE IRA plan and the traditional 401(k) plan are combined into one plan, there are considerable advantages for both employees and business owners. The employees have the opportunity to make elective contributions on a pre-tax basis (salary deferral) and receive a fully vested 4% employer matching contribution. The employees and the business owners may make an elective salary deferral contribution of up to $15,000, for 2006, plus an additional $5,000 catch-up if they are age 50 or over. The SH plan's matching contribution can be used to satisfy the top-heavy nondiscrimination requirement and the non-elective contribution may be used to satisfy both the top-heavy and the coverage non-discrimination requirements. Finally, if sufficient age disparity exists between the owners and the non-owner employees, the owners may be able to maximize the contributions made on their behalf.

Conclusion. The Safe Harbor 401(k) plan does offer some unique planning opportunities in the right setting. Variables such as the number of employees, their ages, and the business objectives and resources play a large part in determining whether the Safe Harbor 401(k) is an attractive retirement plan option for a small business.