A Guide to Safe Harbor 401(k) Plans for Small Businesses - Including SECURE 2.0 Changes

Safe harbor 401(k) plans are the most popular type of 401(k) plan sponsored by small businesses today. They are exempt from the nondiscrimination tests that small business 401(k) plans often fail. A 401(k) plan must meet certain employer contribution and participant disclosure requirements to achieve safe harbor status. This trade-off can be a win-win for business owners and their employees.

We receive many questions about safe harbor 401(k) plans from small businesses. In this guide, we’ll answer the most common. It incorporates the law changes made by the SECURE Act of 2019 (SECURE 1.0) and SECURE Act of 2022 (SECURE 2.0).

Safe harbor 401(k) plans are not subject to the ADP/ACP and top heavy nondiscrimination tests that traditional (non-safe harbor) plans must pass to prove annual contributions do not disproportionately favor Highly Compensated Employees (HCEs) over Non-Highly Compensated Employees (NHCEs). To achieve safe harbor status, a 401(k) plan must comply with employer contribution rules and participant disclosure requirements.

Safe harbor plans come in two basic forms:

• • Classic safe harbor – the original form.
  • Qualified Automatic Contribution Arrangement (QACA) - includes an automatic enrollment feature and different contribution requirements than the original form.

Safe harbor 401(k) plans are most popular with businesses who would fail the ADP/ACP or top heavy tests with a traditional plan and/or who want to offer a generous employer contribution. Safe harbor plans are particularly popular with small businesses, who are more likely than large businesses to fail the ADP/ACP and top heavy tests.

A safe harbor 401(k) plan can be a win-win for business owners and their employees.

• • Guaranteed contributions – No ADP/ACP testing means no risk of contribution refunds to correct a failed test – which guarantees owners can defer up to the 402(g) limit annually ($23,000 for 2024 / $30,000 for catchup-eligible owners).  
  • Simplified administration – The ADP/ACP and top heavy tests can require a large amount of data and technical calculations to prepare properly. A safe harbor plan can make this effort unnecessary.
  • Enhanced recruitment and retention – the generous employer contribution requirements of a safe harbor plan can help a business attract and retain talent.

• • Guaranteed contributions – safe harbor contributions ensure employees receive additional funds towards their retirement savings, above and beyond what they might save on their own.
  • Accelerated vesting – Classic safe harbor contributions must be 100% vested when made, while QACA contributions can require no more than two years of service to fully vest.
  • Faster savings – guaranteed employer contributions with accelerated vesting mean more savings to compound until retirement.

A 401(k) plan must make a qualifying matching or nonelective contribution to participants to achieve safe harbor status. The contribution requirement depends upon the safe harbor plan’s classic or QACA status.

1. Basic match - 100% of the first 3% of compensation and an additional 50% on the next 2% of compensation (4% of compensation total).

2. Enhanced match – must equal or exceed the basic match at each tier. A common enhanced match is 100% match on the first 4% of compensation. 

3. Nonelective contribution - 3% (or more) of compensation, regardless of how much the employee defers.

1. Basic match - 100% of the first 1% of compensation, plus 50% on the next 5% of compensation (3.5% of compensation total).

2. Enhanced match – must equal or exceed the basic match at each tier. A common enhanced match is 100% match on the first 3.5% of compensation. 

3. Nonelective contribution – same formula requirement as classic plans. 3% (or more) of compensation, regardless of how much the employee defers.

A participant disclosure requirement applies to some safe harbor 401(k) plans. These plans must distribute a safe harbor notice to eligible employees annually.

All match-based plans must distribute a safe harbor notice to participants.

Nonelective-based plans generally have no notice requirement. An exception applies for safe harbor plans with a contingent (or "maybe") nonelective contribution.

When a safe harbor plan includes a “maybe” nonelective contribution, employers can decide whether or not to make the contribution later in the year. These plans will be subject to ADP/ACP and top heavy testing for years in which a nonelective contribution is not made.

The safe harbor notice for a "maybe" nonelective plan must explain the contingent nature of the contribution. A follow-up notice must be distributed if a nonelective contribution will be made for the year.

When applicable, a safe harbor notice must be distributed to plan participants within a reasonable period before the start of each plan year. In general, “reasonable” means:

• • 30-90 days before the start of each plan year.
  • For new participants, generally no earlier than 90 days before their plan entry date and no later than that date.

The notice must contain the following information:

• • The formula for the safe harbor matching or nonelective contribution.
  • Information about other plan contributions, including the potential for discretionary contributions.
  • A description of the wages that employees can contribute.
  • Instructions for making deferral elections, including any requirements that apply to the elections.
  • The frequency that deferral elections can be changed.
  • Vesting and distribution provisions applicable to contributions.
  • How to obtain additional information about the plan.

Safe harbor 401(k) plans are popular with small businesses because owners tend to bear the brunt of the consequences when the ADP/ACP and top heavy tests fail. A safe harbor plan guarantees no contribution refunds for owners, while costing a business about the same as a top heavy traditional plan.

The Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests measure the elective deferrals and matching contributions of Highly-Compensated Employees (HCEs) for nondiscrimination.

For 2024, an HCE is defined as an individual that meets one of the following criteria: 

• • They own more than 5% of the employer (either directly or by family attribution) at any time during 2023 or 2024, or
  • They received more than $150,000 in compensation from the employer during 2023. Alternatively, a plan may also limit this group to the top 20% of employees, ranked by compensation.

When the ADP/ACP test fails, the most common correction method is refunding the contributions made to HCEs in the amount necessary to pass the applicable test.

A 401(k) plan is considered top heavy for a plan year when the account balances of “key employees” exceed 60% of total plan assets as of the last day of the prior plan year.

For 2024, a “key employee” is defined as any employee (including former or deceased employees), who at any time during the plan year was:

• • An officer making over $220,000, or
  • A 5% owner of the business (a 5% owner is someone who owns more than 5% of the business), or
  • An employee owning more than 1% of the business and making over $150,000 for the plan year.

When a 401(k) plan is top heavy, all non-key employees employed on the last day of the plan year must receive a top heavy minimum contribution. The required amount must equal the lesser of:

• • 3% of compensation,
  • The highest contribution rate for any key employee – including elective deferrals.

The required amount for a non-key employee is offset by any employer contributions received during the year.

In 2020, we studied 3,217 small business 401(k) plans to learn the percentage that failed the ADP/ACP and top heavy tests. We found 26.47% of traditional plans failed the ADP test, while 45.41% of all plans were top heavy. I think it’s safe to assume the percentage of safe harbor plans that would have failed ADP test had they NOT been safe harbor would be higher than 26.47%.

*Excluding safe harbor plans

Reasons to choose a safe harbor 401(k) plan:

• • The plan will be top heavy. Because a top heavy 401(k) plan must generally make a 3% minimum contribution to non-key employees, the 3% nonelective contribution will cost about the same. The 4% match might even cost less than the top heavy minimum contribution if participants defer at low rates.
  • The plan will fail the ADP and/or ACP test. A safe harbor plan allows HCEs to maximize their annual contributions without fear of refund due to failed testing.
  • Business owners want to offer a generous employer contribution.

Reasons to choose a traditional 401(k) plan:

• • The plan will have no trouble passing the ADP/ACP and top heavy tests.
  • Business owners want to discourage employee turnover by adding allocation conditions (e.g., 1,000 hours, employment on last day of plan year) and/or vesting schedule to matching contributions.
  • Business owners want to use a “stretch” match formula (e.g., 25% of elective deferrals up to 10% of compensation) to incentivize employees to make bigger elective deferrals. 

In general, the first year of a new safe harbor 401(k) plan must be at least 3 months long – to give all plan participants the opportunity to make elective deferrals. That means the deadline for employers to adopt a new calendar-based plan is October 1.

A 401(k) plan must be formally amended to convert from a traditional to a safe harbor plan. The deadline for adopting this amendment will depend upon the type of safe harbor contribution to be made.

• • Safe harbor match – amendment deadline is the last day of year preceding the plan year in which the plan will be safe harbor.
    • • However, match-based safe harbor plans must distribute a safe harbor notice to participants sooner - 30-90 days before the start of the plan year. The SECURE Act eliminated the safe harbor notice requirement for nonelective-based plans.
  • Safe harbor nonelective – The SECURE Act made the amendment deadline much more flexible for these plans. It’s based on the nonelective contribution formula:
    • • Less than 4% - up to 30 days before the close of the plan year in which the plan will be safe harbor.
      • 4% or greater - The last day of the plan year following the plan year in which the plan will be safe harbor (i.e., the deadline for distributing ADP/ACP corrective refunds).

All SIMPLE IRAs operate on a calendar basis. Further, a SIMPLE IRA must be the sole retirement plan maintained by an employer. Before January 1, 2024, employers had to maintain a SIMPLE IRA for the entire calendar year. SECURE 2.0 now allows employers to terminate a SIMPLE IRA at any time during the year by replacing the terminated plan with a safe harbor plan.

However, this replacement process is subject to special timing and contribution limit requirements. Some coordination is necessary to meet these requirements. We recommend a five-step process:

1. 1. Establish the safe harbor plan’s start date.
   2. Terminate the SIMPLE IRA effective the day before the start date.
   3. Notify employees about the replacement.
   4. Properly limit elective deferrals.
   5. Confirm deferral limits were not exceeded.

To amend a safe harbor 401(k) plan mid-year, an employer must meet the following requirements if the amendment will affect the content of the safe harbor notice provided before the start of the plan year:

• • Distribute a new notice to eligible employees 30-90 days before the effective date of the amendment.
  • Give eligible employees a reasonable opportunity to change their deferral election before the amendment’s effective date. A 30-day election period is deemed reasonable.

The mid-year amendment cannot include a change prohibited in Notice 2016-16. Prohibited amendments include:

• • Increasing the number of years required for full vesting of QACA safe harbor contributions.
  • Narrowing the group of employees eligible to receive safe harbor contributions if the employees have already met the existing eligibility conditions.
  • Changing the type of safe harbor plan (e.g., traditional safe harbor to QACA safe harbor).
  • Modifying a match formula that increases contributions or adding a discretionary match within three months of year-end. This change is permitted if made prior to three months before year-end and the change is retroactive to the beginning of the plan year.

A safe harbor match or nonelective contributions (as applicable) can be reduced or suspended mid-year when all of the following conditions are met:

• • Either of the following conditions apply:
    • • The plan sponsor is operating at an economic loss.
      • The safe harbor notice provided before the start of the plan year states that contributions can be suspended mid-year.
  • A supplemental notice is distributed to eligible employees at least 30 days before the effective date of the reduction or suspension.
  • Eligible employees have a reasonable opportunity to change their deferral election before the reduction or suspension occurs.
  • The plan is ADP/ACP tested for the full plan using the current year testing method.
  • The plan meets the safe harbor requirements for compensation paid through the effective date of the reduction or suspension.
  • The reduction or suspension is effective no earlier than the later of:
    • • 30 days after the supplemental notice if provided to employees; or
      • The date the amendment is signed.

Safe harbor and traditional 401(k) plans have trade-offs. For small business owners to make the best choice, they must know how to weigh the pros and cons of these plans. Our guide can help.