Retirement Meditation #34: Why do I get some of my 401(k) plan contributions returned to me every year?

Insights | Retirement Meditation #34: Why do I get some of my 401(k) plan contributions returned to me every year?
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Author: Paul A. Carl, CHSA, CPFA Vice President, Retirement Plan Consulting, Registered Representative

I worked with a client whose Vice President, Finance purposely kept her compensation exactly $1 below the IRS definition of Highly Compensated Employee. She refused bonuses, “excessive” pay raises, and higher paying positions at other companies. She wanted to achieve her retirement savings goals as quickly as possible. She always contributed the maximum deferral limit and she received the employer’s generous dollar-for-dollar match which added another ten percent of compensation to her 401(k) account. Each year, she quietly watched her retirement account balance grow while her higher paid colleagues received the return of portions or all of their deferrals, employer match, and related earnings. So why didn’t the employer adopt a safe harbor provision? It was 1995 and safe harbor plans did not exist.

If you sponsor a 401(k) plan, act as a 401(k) plan fiduciary, or meet certain IRS employee definitions, you likely know firsthand that a 401(k) plan is subject to IRS-mandated compliance testing. The most known compliance tests, commonly called “non-discrimination tests,” compare the employee deferral and employer match contribution averages of IRS-defined highly compensated employees to those of non-highly compensated employees. When a test fails, excess contributions that cannot be re-characterized must be removed from certain affected highly compensated employee 401(k) accounts. Sometimes the excess contributions are refunded and sometimes – such as non-vested employer match – they are forfeited. While the idea behind non-discrimination testing rules may be admirable (to keep an employer from offering only certain classes of employees retirement benefits), the compliance testing is complicated and can result in certain households under-saving for retirement. 

Congress created the safe harbor plan in 1996’s Small Business Job Protection Act (SBJPA) which introduced three safe harbor formulas. While the original safe harbor formulas remain in place, additional safe harbor formulas and rules have followed. By adopting and adhering to the safe harbor rules, an employer helps assure its more highly paid employees that they have an avenue to save for retirement. 

Employers are under no obligation to adopt safe harbor and safe harbor may not be the best solution for every employer. Safe harbor plans – with limited exception – require the employer safe harbor contribution to be 100% vested, or immediately owned by the employee receiving the safe harbor contribution. Employers with high turnover, especially within the first few years of employment, may find the fully vested safe harbor contribution to simply be too costly.

Is it time to review your plan provisions and consider safe harbor?

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