Missing Participants: Ready or Not, Here I Come!

A crucial requirement for 401(k) plans is that the plan must be designed so it does not unfairly favor highly compensated employees (HCEs) or key employees (such as owners) over non-highly compensated employees (NHCEs). To satisfy this requirement, the IRS requires that plans pass certain nondiscrimination tests each plan year. These tests analyze the rate at which HCE and key employees benefit from the plan in comparison to NHCEs. Failed tests can result in costly corrections, such as refunds to HCEs and key employees or additional company contributions. Luckily for plan sponsors, there is a plan design option - a safe harbor feature, that allows companies to avoid most of these nondiscrimination tests.

To be considered safe harbor and take advantage of the benefits afforded to safe harbor plans, there are several requirements that must be satisfied. Below we will take a look at the key characteristics of a safe harbor plan.

The plan must include one of the following types of contributions. The chosen formula is written in the plan document, and with the exception of HCEs, must be provided to all eligible employees each plan year. Please note that additional options, not covered here, are provided for plans that include certain automatic enrollment features.

• Safe Harbor Match: With this option, the company makes a matching contribution only to those employees who choose to make salary deferral contributions. There are two types of safe harbor matching contributions:
  • Basic Safe Harbor Match: The company matches 100% of the first 3% of each employee's contribution, plus 50% of the next 2%.
  • Enhanced Safe Harbor Match: Must be at least as favorable as the basic match. A common formula is a 100% match on the first 4% of deferred compensation.
• Safe Harbor Nonelective: With this option, the company contributes at least 3% of pay for all eligible employees, regardless of whether the employee chooses to contribute to the plan.

Unlike company profit sharing or discretionary match contributions, safe harbor contributions must be 100% vested immediately. In addition, the contribution must be provided to all eligible employees, even those who did not work a minimum number of hours during the plan year or who are not employed on the last day of the plan year.

In most cases, an annual safe harbor notice must be distributed to plan participants within a reasonable period before the start of each plan year. This is generally considered to be at least 30 days (and no more than 90 days) before the beginning of each plan year. For new participants, the notice should be provided no more than 90 days before the employee becomes eligible and no later than the employee's date of eligibility. The safe harbor notice informs eligible employees of certain plan features, including the type of safe harbor contribution provided under the plan.

If all safe harbor requirements have been satisfied for a plan year, the following nondiscrimination tests can be avoided.

• Actual Deferral Percentage (ADP): The ADP test compares the elective deferrals (both pre-tax and Roth deferrals, but not catch-up contributions) of the HCEs and NHCEs. A failed ADP must be corrected by refunding HCE contributions and/or making additional company contributions to NHCEs.
• Actual Contribution Percentage (ACP): The ACP test compares the matching and after-tax contributions of the HCEs and NHCEs. A failed ACP must be corrected by refunding HCE contributions and/or making additional company contributions to NHCEs.
• Top Heavy Test: The top heavy test compares the total account balances of key employees and non-key employees. If the total key employee balance exceeds 60% of total plan assets, an additional company contribution of at least 3% of pay may be required for all non-key employees. It is important to note that a plan will lose its top heavy exemption if company contributions, in addition to the safe harbor contribution, are made for a plan year (e.g., profit sharing or discretionary matching contributions).

So, how do you know if a safe harbor plan is a good fit for your company? As discussed above, the primary benefit of a safe harbor plan is automatic passage of certain annual nondiscrimination tests. If your plan typically fails these tests, resulting in refunds or reduced contributions to HCEs and key employees, your company may benefit from a safe harbor feature. Predictable annual contributions also provide a great incentive for employees to save for their retirement. However, if you do not currently offer an annual match or profit sharing contribution to your employees, a safe harbor formula may significantly impact your company's budget. Except for a few limited exceptions, safe harbor contributions cannot be removed during the plan year, so it's important that a company is able to fund these required contributions. As with all things qualified plan related, the key is working with an experienced service provider who can design a plan to suit your company's needs! ■

So, you established a 401(k) plan for your company and have been contributing consistently for years. The plan has likely afforded your company significant tax savings and has allowed you to attract and retain quality employees. While a 401(k) plan is a great savings vehicle, did you know there is a type of qualified retirement plan that will allow you to contribute significantly more than the maximum allowed in a stand-alone 401(k) profit sharing plan?

 The plan has likely afforded your company significant tax savings and has allowed you to attract and retain quality employees. While a 401(k) plan is a great savings vehicle, did you know there is a type of qualified retirement plan that will allow you to contribute significantly more than the maximum allowed in a stand-alone 401(k) profit sharing plan?

As mentioned above, a cash balance plan is a type of defined benefit plan. In general, defined benefit plans provide a specific benefit at retirement to participants. While traditional defined benefit plans define an employee's benefit as a series of monthly payments for life to begin at retirement, cash balance plans state the benefit as a hypothetical account balance. Each year, this hypothetical account is credited with following:

• A pay credit, such as a percentage of annual pay or a fixed dollar amount that is specified in the plan document.
• A guaranteed interest credit (either a fixed rate or a variable rate that is linked to an index such as the one-year treasury bill rate).

The accounts in a cash balance plan are referred to as hypothetical because, unlike defined contribution plans, the plan assets are held in a pooled account managed by the employer, or an investment manager appointed by the employer. The hypothetical account balances are an attractive feature of cash balance plans because these accounts tend to be easier for participants to understand, as the annual benefit statements reflect the value of their account, similar to 401(k) profit sharing plan account statements.

Unlike a 401(k) profit sharing plan, a defined benefit plan guarantees the benefit each participant will ultimately receive. The plan's actuary calculates the benefits earned each year based on the terms of the plan document, which in turn determines the required employer contribution due to the plan.

When a participant becomes entitled to receive their benefit from a cash balance plan, the benefits are defined in terms of an account balance and can be paid as an annuity based on that account balance. In many cash balance plans, the participant also has the option (with consent from his or her spouse) to take a lump sum benefit that can be rolled over into an IRA or to another employer's plan.

In most cases, cash balance plans work best when paired with a 401(k) profit sharing plan. To optimize the combined plan design, it's possible that certain provisions in your current plan may need to be amended. This is especially true if the cash balance plan covers non-owner employees. Due to the large benefits that are typically earned by the owner and/or other key employees, the combined plans must pass certain nondiscrimination tests. These tests are more easily passed when employer contributions are provided to the staff under the 401(k) profit sharing plan as safe harbor nonelective and profit sharing contributions. While company contributions in a stand-alone 401(k) profit sharing plan may be discretionary, when combined with a cash balance plan, these contributions become required as well, since without them, the combined plans will likely not pass all required nondiscrimination tests.

Unfortunately, the answer to this question is no. The first question to ask yourself is if you wish to make contributions in excess of the defined contribution limit ($58,000 or $64,500 for participants over age 50 for 2021). If the answer to this is yes, then the demographics of the employer must be considered. Since the maximum contributions are age dependent, cash balance plans typically work best when targeted employees are older than the average age of other staff members. And maybe most importantly - do you anticipate consistent profits that will allow you to fund all required contributions for the foreseeable future?

If you've decided setting up a cash balance plan sounds like the perfect way to meet your retirement goals and attract and retain quality employees, you may be right! However, as good as this sounds, there are many important factors to consider before jumping in. Here are a few key considerations:

• Cash balance plans can be designed with some flexibility, such as setting up pay credits using a percentage of annual pay, but the annual contribution calculated by the actuary is required. When paired with a 401(k) profit sharing plan to pass nondiscrimination testing, the employer contributions to that plan become required as well.
• Because the annual interest credit is guaranteed, the employer bears the investment risk for the plan. If the rate of return on investments is less than expected, the required contribution may increase to make up for the shortfall.
• Qualified retirement plans must be established with the intent of being permanent. Many service providers recommend maintaining the plan for at least three to five years to satisfy this requirement.
• Cash balance plans are often more complex, and as a result, more costly to establish and maintain than defined contribution plans.

For employers that desire increased retirement savings and tax deductions, cash balance plans may be the perfect addition to their employee benefit program. However, as previously mentioned, they are not a good fit for everyone. It's important to work with an experienced service provider to determine if a cash balance plan is right for you. ■