401(k) Testing and Compliance: Is a Safe Harbor Plan Really Frugal?

At Employee Fiduciary, March is a busy month. And no, I’m not talking about putting together our NCAA brackets. Corporate tax returns are due March 15, which means we are helping our clients analyze the deductibility of 2012 contributions. We are busy completing 401(k) plan testing and compliance.

In a perfect world, all employees would make the maximum contributions to their plan and reap the rewards come retirement time. But for many employees, putting aside money for retirement is difficult - many need their paycheck in its entirety just for everyday living expenses. On the other hand, highly compensated employees have the ability to make larger contributions to the plan. The IRS has rules that limit deductibility of plan contributions. Basically, the wealthy can max out only if the less well compensated make significant contributions as well.

Because of this, we have seen many of our own clients choose to invest in a 401(k) plan with “safe harbor” provisions. The 401(k) safe harbor plan allows highly compensated owner-employees to make maximum contributions even if their employees make smaller contributions - or no contribution at all.

With this kind of plan in place, a small business owner doesn’t run the risk of failing a non-discrimination test (safe harbor plans don’t require discrimination testing) and triggering a refund of contributions, which then are taxed as part of personal income.

But what’s the catch? And does it violate the principles of frugality?

The catch is that the employer must make contributions directly to the account of all plan participants as high as 3.5% of compensation. Under most safe harbor provisions, the contribution vests immediately to the employee’s account, regardless of tenure. Sounds like an expensive way to get a tax deduction.

Allow me to retort.

I like 401(k) safe harbor plans (our own Employee Fiduciary plan is safe harbor) for the following reasons:

• A safe harbor match is the best incentive available to get employees saving. A matching contribution gets even reluctant savers to jump in.
• Good will. We treat it as a part of our benefits package. Employees appreciate the benefit, and the company benefits from employee retention.
• Even the boss gets the match. I need to save as well.
• And the company gets a deduction for the match, effectively reducing the cost of the match by about 1/3, a typical marginal tax rate.

The frugal fiduciary recommending spending money??? Yes, frugal is prudent and careful, and getting to a win-win with employees is a frugal way of doing business.