The Safe-Harbor Solution

Small business retirement planning just got easier.

  • EFFECTIVE IN 1999, The Small Business Job Protection Act of 1996 introduced safe-harbor formulas for 401(k) plans that eliminate the need for companies to perform annual nondiscrimination testing. These changes should allow small employers to contribute higher amounts on behalf of highly compensated employees (HCEs).
  • NONDISCRIMINATION TESTS effectively eliminate the ability of many small businesses and professional firms to adopt 401(k) plans because non-HCEs often elect not to participate. The result is that HCEs can defer little or no income under the plan.
  • THE SAFE-HARBOR FORMULAS provide a way for employers to avoid nondiscrimination testing by adopting a plan with a relatively generous employer match—one that includes a contribution of at least 4% of pay on behalf of all eligible employees (depending on employee contributions).
  • SAFE-HARBOR MATCHING contributions must be 100% vested at all times. Such contributions generally may not be distributed to employees until the earlier of when they terminate employment or reach age 59 12.
CHARLES W. SHERMAN, JR., JD, is a principal of the Groom Law Group, Chartered, in Washington, D.C. His e-mail address is MICHAEL J. COLLINS, JD, is an associate with the Groom Law Group, Chartered. His e-mail address is .

or many years small businesses wanting to set up retirement plans faced a formidable barrier—the complex and time-consuming nondiscrimination testing the law requires. However, effective for plan years beginning in 1999, the Small Business Job Protection Act of 1996 introduced safe-harbor formulas for 401(k) salary deferral and matching contributions that eliminated the need for employers to perform annual nondiscrimination testing. By adopting the safe-harbor formulas that are outlined below, small employers may be able to contribute higher amounts on behalf of owners, partners and other highly compensated employees (HCEs) while reducing the amounts contributed on behalf of non-HCEs.


A non-safe-harbor 401(k) plan that includes employer matching contributions must satisfy two nondiscrimination tests:

  • The actual deferral percentage (ADP) test (IRC section 401(k)(3) (A)(ii)), which generally limits 401(k) salary deferrals by HCEs based on how much non-HCEs defer.
  • The actual contribution percentage (ACP) test (IRC section 401(m) (2)(A)), which similarly limits matching contributions on behalf of HCEs.

For purposes of these tests, an HCE generally is an employee who was a 5% owner at any time in the prior or current year or who earned $80,000 or more in the prior year.

The ADP and ACP tests effectively eliminate the ability of many small businesses and professional firms (doctors, CPAs, lawyers) to adopt 401(k) plans because most or all non-HCEs may elect not to participate. Non-HCEs typically are less likely to participate in 401(k) plans because they lack the necessary disposable income. As a result, HCEs may be able to defer little or no income under the plan.

Small Business Workers Need a Break

At a time when U.S. retirement savings are at an all-time low, employees of small businesses—those with fewer than 100 employees—seem to be at a particular disadvantage.

  • More than two-thirds were not covered by retirement plans.
  • When they were covered, only half of their employers offered retirement education. As a result, only 1 in 5 participated in the plan compared with 8 of 10 employees in large companies.
  • In a 1998 retirement confidence survey of Americans 25 or older, only 25% of the respondents said they believed they would have enough money to live on after retirement.

Source: Department of Labor Working Group on Small Business of the ERISA Advisory Council, November 1998.


The good news for thousands of small business owners is that the ADP and ACP safe harbors offer significant planning opportunities. Under the 1996 act, small employers can adopt matching 401(k) plans without concern about whether non-HCEs elect to participate. Depending on how attractive non-HCEs find the safe-harbor matching formula, the use of the safe harbors may reduce substantially the employer contributions businesses must make on behalf of these employees.

How? The safe harbors are substitutes for nondiscrimination testing that provide a way for employers to adopt a plan with a relatively generous employer match—up to 4% of pay on behalf of all eligible employees, depending on the amount an employee defers. While all safe-harbor contributions must be fully and immediately vested and the plan sponsor must provide each eligible employee with an annual written notice, the safe harbors otherwise put few restrictions on employers.

ADP safe harbor. A 401(k) plan satisfies the ADP safe harbor if it meets the contribution and notice requirements and complies with various other rules. (This article focuses only on using matching contributions to satisfy the safe harbor. Using nonmatching contributions usually is more expensive for a company and does not offer the same planning opportunities.)

An employer satisfies the ADP safe-harbor matching contribution requirement if it implements either a basic matching formula or an enhanced matching formula. Under the basic formula, the employer matches 100% of employee salary deferrals up to 3% of compensation and 50% of deferrals from 3% to 5% of compensation. Under the enhanced formula, the employer provides a match that—at any rate of 401(k) salary deferrals—provides a match at least as great as the basic formula. Matching contributions under the enhanced formula may not increase as the employee’s rate of 401(k) salary deferrals increases and the company may not match HCE contributions at a greater rate than it matches non-HCE contributions.

The notice the company provides to employees must satisfy both content and timing requirements. It must be accurate and comprehensive enough to inform an employee of his or her rights and obligations under the plan and must be written so the average eligible employee can understand it. Generally, the company must distribute the notice between 30 and 90 days before the beginning of the plan year (the plan’s fiscal year). In 1999, a transition rule applied for plan years beginning before April 1.

ACP safe harbor. To be eligible for ACP safe-harbor treatment, a plan first must satisfy the ADP safe-harbor rules. In addition, the plan must satisfy other rules, including limits on the amount of matching contributions. If the plan uses the basic matching formula, it can’t provide for other matching contributions. If the plan uses the enhanced matching formula, matching contributions cannot exceed 6% of an employee’s compensation. For any other kind of plan, three requirements apply:

  1. The company cannot match an employee’s aftertax contributions or match 401(k) deferrals that exceed 6% of the employee’s compensation.
  2. The rate of matching contributions cannot increase as the rate of an employee’s aftertax contributions increases.
  3. The rate of matching contributions for any HCE cannot be greater than the rate of matching contributions for any non-HCE.


The following example illustrates how a small employer can use the ADP and ACP safe harbors to increase contributions on behalf of HCEs. Consider a small importing company, Holiday Treasures, with two partners, A and B, and a secretary, C. A has annual compensation of $150,000, B of $120,000 and C of $30,000. The company wants to make the maximum deductible annual contribution under its 401(k) plan—$45,000—and allocate as much of the contribution as possible to A and B. (The $45,000 limit is 15% of total employee compensation under IRC section 404(a)(3)(A)).

Holiday Treasures can adopt a profit-sharing plan that allocates its $45,000 contribution based on each individual’s relative compensation—$22,500 to employee A, $18,000 to employee B and $4,500 to employee C. Alternatively, the company can adopt a plan integrated with Social Security. Under an integrated formula that produces the maximum contributions on behalf of A and B, the $45,000 contribution is allocated $23,355 to A, $17,886 to B and $3,759 to C. (This example assumes the Social Security wage base is $70,000.)

Or, Holiday Treasures can, instead, adopt a safe-harbor 401(k) plan that provides a 100% match on deferrals up to 6% of compensation. Assume that, after receiving notice of this safe-harbor program, employee C decides not to defer anything under the plan. A and B defer $10,000 (the maximum allowable annual 401(k) contribution under IRC section 402(g)) each. The company contributes the difference between the $45,000 maximum deductible contribution and the total 401(k) and matching contributions. After these amounts are allocated on the basis of the proportionate compensation of A, B and C, the results are as shown in exhibit 1.

Exhibit 1: Holiday Treasures 401(k) Allocation—Employee C Does Not Contribute
Match Profit
Total and
of Pretax
A $10,000 $9,000 $4,400 $23,400   15.6%
B $10,000 $7,200 $3,520 $20,720   17.3%
C $880 $880   2.9%

As exhibit 1 shows, C is allocated only $880, as opposed to $4,500 under a profit-sharing plan that is not integrated with Social Security and $3,759 under a plan that is integrated. While A is allocated only slightly more than under the previous examples, B receives a significantly higher allocation. This gap can be narrowed if B does not make a full $10,000 salary deferral. Exhibit 2 shows the results if B defers only $7,200 (so she receives the full match available under the matching formula) under both integrated and nonintegrated plans.

Exhibit 2: Holiday Treasures 401(k) Allocation—Employee B Contributes $7,200 Employee C Does Not Contribute
Match Profit
A $10,000 $9,000 $5,800 $24,800 $6,020 $25,020
B $7,200 $7,200 $4,640 $19,040 $4,611 $19,011
C $1,160 $1,160 $969 $969

If employee C elects to defer 6% of his compensation under the plan, the allocations are as shown in exhibit 3. At first glance, if employee C decides to make elective deferrals to the plan in order to receive the maximum match, the ultimate allocations appear to be roughly the same as if Holiday Treasures had not adopted a safe-harbor formula. However, this is deceiving, because $1,800 of the allocation to C represents employee contributions. Consequently, the net cost to the employer is $2,320 ($4,120 less $1,800), a significantly lower cost than if the company does not use the safe harbors.

Exhibit 3: Holiday Treasures 401(k) Allocation—Employee C Contributes 6%
Match Profit
Total and
of Pretax
A $10,000 $9,000 $2,600 $21,600   14.4%
B $10,000 $7,200 $2,080 $19,280   16.1%
C $1,180 $1,180 $520 $4,120   13.7%


Small employers such as Holiday Treasures may be able to allocate higher amounts to HCEs relative to non-HCEs by using the safe harbors. However, there may be a few additional costs:

  • Safe-harbor matching contributions must be 100% vested at all times. Non-safe-harbor contributions, on the other hand, generally can be subject to three-year “cliff” or six-year “graded” vesting schedules, assuming the plan is top-heavy. Under cliff vesting, an employee does not vest at all until after completing three years of service and is 100% vested at that time. Under a graded schedule, the employee vests 20% after two, three, four, five and six years of service.
  • The 401(k) salary deferrals are subject to FICA tax, while non-401(k) contributions (including matching contributions) are not. Assuming an HCE defers $10,000, the additional FICA cost is $290 (only the Medicare portion of FICA applies because HCEs earn in excess of the maximum Social Security wage base).
  • The safe-harbor matching contributions generally may not be distributed until the earlier of when an employee terminates employment or attains age 59 12. Traditional profit-sharing contributions may be subject to more liberal in-service distribution rules.
  • An employer must prepare and distribute the annual safe-harbor notice. The cost of doing so is unlikely to be significant after the first year because, assuming the matching formula does not change, an employer should be able to distribute the same basic notice each year.
  • The IRS’s position is that safe-harbor matching contributions may not count toward satisfying any top-heavy contribution requirements. If a company uses a safe-harbor formula and its plan is top-heavy, the company may be required to make additional employer contributions so each non-key employee is credited with total non-401(k) and nonmatching contributions of 3% of compensation. Unfortunately, 401(k) and matching contributions do not count toward satisfying the 3% minimum for top-heavy plans.


Americans are saving less than at almost any time since the Commerce Department began collecting data in 1925. In 1997, they saved only 2.1% of their disposable income. As recently as 25 years ago, the rate was at a postwar high of 9.5%. To help themselves and their employees prepare for the financial challenge of retirement, small employers should seriously consider adopting safe-harbor 401(k) matching plans. The benefits of doing so can be significant. The safe harbors may allow higher deferrals by partners or owners and other HCEs, while at the same time reducing the required contributions for other employees. More important, even a small push toward saving will help employer and employee alike prepare for the future.


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