Impact of plan design

While a plan implementing automatic enrollment is a reliable way to increase the number of participants in the plan it doesn’t necessarily follow that an increased number of participants will aid in a plan passing the contribution percentage comparisons tests – ADP and ACP.

These tests allow for a difference in average contribution rates of the “highly compensated” and “non-highly compensated” of 2% but what if your test shows a 5% disparity? If the HCE average contribution is 7% and the average of the non-HCE's is 2% implementing automatic enrollment might help but this plan would have to start the automatic savings rate at 5% to be reasonably assured that they will pass future tests.

A more certain way of assuring passage of these tests is to amend the plan to offer “Safe-Harbor” contributions. What is a Safe Harbor contribution? If an employer is willing to make certain minimum contributions to plan participants those companies would receive some relief from the deferral percentage tests that plague many 401(k) plans. The Safe Harbor contributions can take the form of a matching contribution which is made only to employees that make their own contributions to the plan or the employer can make a contribution of 3% of eligible pay to all eligible employees – a safe-harbor profit sharing contribution. The matching formula can either be a dollar for dollar match of employee contributions up to the first 4% of eligible pay or dollar for dollar match on the first 3% and fifty cents on the dollar for the next 2% of pay. In the first example the participant would need to contribute 4% of pay to reach the maximum matching amount and in the second instance the participant would have to defer 5% of pay to receive the maximum. Participants that do not contribute their own money recieve no contribution.

If a company is currently matching 25 cents or 50 cents on the dollar for the first 6% of pay the safe-harbor represents a pretty meaningful increase in employer contributions. Many employers, which are often owners of the company, decide this extra expense is worth it as it allows them to maximize their own contributions to the plan. If the owners are in a high tax bracket the inability to maximize contributions results in higher individual taxes, the choice becomes whether to pay taxes or pay that money to employees in the form of a match.

Safe-harbor contributions are 100% vested from the day they go into the plan so if a vesting schedule that requires a certain number of years of service to become vested in company contributions is a key employer desire then the safe-harbor approach might not be the answer.

Subject Reference Information