SOLUTIONS IN A FLASH- RETIREMENT PLAN CORRECTION SOLUTION:
BILBO BAGGINS FINDS SAFE HARBOR IN THE SHIRE

by: Isaac K. Thuesen, Esq.

Bilbo lives a quiet, comfortable life in the Shire. He owns a farm and employs several workers, including his honorary nephew, Frodo. One day, wanting to show his appreciation for his beloved employees, Bilbo sets up the Bilbo Baggins’s Benefits 401(k) plan (“BBB 401(k)”). He includes an employer match to make sure his current employees are well provided for and to incentivize other hobbits to work for him.

Before Bilbo can dive into the nuts and bolts of plan administration, however, the wizard Gandalf shows up to his house with a rowdy band of dwarves. Before Bilbo knows it, he is whisked away on an epic adventure. Bilbo, a homebody to the core, worries about what will happen to him, his employees, and the BBB 401(k).

The Benefits of Safe Harbor Plans

It turns out Bilbo was right to be worried. Deep in the forests of Mirkwood, he and the dwarves are confronted by a cluster of giant spiders! When Bilbo sees his friends wrapped in the spiders’ web, it is all he can do not to run away. Summoning what little courage he has, he scares the spiders off with his trusty sword, Sting. Later that night, he falls into an uneasy sleep. What he sees next makes him wish he was back in the spiders’ hairy embrace: Gandalf appears in his dream, and tells him that the BBB 401(k) has failed discrimination testing this year! However, Gandalf says there is hope. Once Bilbo gets back to the Shire, he can help prevent problems like this from recurring by converting his plan to a safe harbor design. Gandalf explains that safe harbor designs protect against discrimination testing issues. In fact, if Bilbo implements the right safe harbor design, the BBB 401(k) plan can be exempt from both Actual Deferral Percentage (“ADP”) testing and Actual Contribution Percentage (“ACP”) testing.

Gandalf further explains that, in order to make the BBB 401(k) a safe harbor plan, Bilbo will first have to review the plan’s definition of compensation for both employee deferrals and employer contributions. The definition of compensation for deferrals and for employer contributions must be nondiscriminatory, and would generally include bonuses, elective contributions or deferred compensation, fringe benefits, moving expenses, and welfare benefits. This definition must also allow all of Bilbo’s non-highly compensated employees (“NHCEs”) to defer enough to receive the maximum matching contribution under the plan, and must neither exclude compensation in excess of a specified amount, nor limit itself to a certain percentage of total compensation. Additionally, Bilbo will have to make sure that the determination period for both definitions of compensation is either the plan year or the calendar year ending within the plan year, and that this determination period is applied uniformly to all his employees. (Gandalf also tells Bilbo that he can use different definitions of compensation for the deferrals and for the employer contributions, but since safe harbor plans are designed to operate more easily than other plans, why complicate things?)

After Bilbo ensures he is using the right definition of compensation, the next step on the path to safe harbor will be picking a design that involves making regular Qualified Nonelective Contributions (“QNEC”) or Qualified Matching Contributions (“QMAC”) to Bilbo’s NHCEs. (QNECs and QMACs are safe harbor contributions that are fully vested and subject to the same distribution limitations as are salary deferrals by the employees.)

Next, depending on the design he picks, Bilbo will likely have to plan to give his employees safe harbor notices at the beginning of each year. Finally, Bilbo must be aware of certain timing requirements. Since his 401(k) already provides for matching contributions, he must adopt any new safe harbor match provisions before the first day of the plan year in which they go into effect, and keep those provisions in place for the entirety of that plan year. However, if Bilbo opts instead to adopt the safe harbor provision of a 3% QNEC, recent changes under SECURE 2.0 allow him to do so as late as 30 days prior to the end of the plan year, i.e., by November 30 for calendar year plans.

The thought of converting his plan to a safe harbor design is more than enough to stoke Bilbo’s budding sense of adventure. But before he can ask Gandalf questions, his friends shake him awake, and his journey continues.

Common Safe Harbor Plan Designs

Months later, Bilbo finds himself near the end of his journey. He’s confronted incredible dangers in the past few days, including staring down the dastardly dragon Smaug, and getting knocked unconscious during the Battle of Five Armies. As Bilbo recuperates after the battle, Gandalf visits him to continue their discussion of safe harbor plans. He explains that Bilbo has different options for designing his safe harbor plan, including:

1. Basic match—Bilbo contributes a QMAC for each of his NHCEs equal to 100% of deferrals up to 3% of that NHCE’s safe harbor compensation, plus 50% of the amount of deferrals between 3% and 5% of safe harbor compensation.
2. Enhanced match—Bilbo contributes a QMAC to each NHCE that is no less generous than they would have received under a basic match. The ratio of this match to the employee’s deferrals must not increase as the NHCE’s deferrals increase. The most common way of satisfying these requirements is by matching 100% of NHCE deferrals up to 4% of compensation.
3. NECs (“Nonelective Contribution”)—Bilbo makes a QNEC for each NHCE equal to at least 3% of that NHCE’s safe harbor compensation, whether the NHCE defers on his own behalf or not.
4. Qualified Automatic Contribution Arrangement (“QACA”)—Under a QACA design, Bilbo’s employees will be automatically enrolled in the Plan. The default deferral rate for the initial period, i.e., the period between the adoption of the QACA provisions and the end of the following plan year, will be a minimum of 3%, and a maximum of 10%. After this initial period, the maximum may increase to 15% if Bilbo would like, and the minimum increases by 1% each plan year before topping out at least 6% in year 4 and beyond. (If the plan has a 401(k) feature that first was put into the plan after December 29, 2022, it is likely that the maximum must be 10%, as the mandatory automatic enrollment rules of SECURE 2.0 apply.) For the employer contribution, Bilbo may choose between making the same QNEC described above, or a matching contribution equal to no less than the sum of 100% of deferrals up to 1% of the NHCE’s safe harbor compensation, and 50% of deferrals between 1% and 6% of the NHCE’s safe harbor compensation.

Gandalf reminds Bilbo that, depending on the plan design he picks, he may need to provide his employees with safe harbor notices at the start of each plan year (and even if the notices are not required, it is a good idea to provide them anyway).

Even if Bilbo decides he wants to provide the safe harbor QNEC, he can avoid nondiscrimination testing on the matching contribution that he also makes if a few requirements are met.  First, he needs to provide the safe harbor notice. Second:

1. The matching contribution cannot be based on deferrals exceeding 6% of a participant’s safe harbor compensation.
2. No discretionary matching contributions for deferrals can exceed 4% of a participant’s safe harbor compensation.
3. The match rate (that is, the ratio of matching contributions to deferrals) cannot increase as the rate of deferrals increases.
4. The match rate at any level of deferrals cannot be larger for any highly compensated employee (HCE), than it is for any NHCE.

Just as Bilbo is about to doze off again, Gandalf seizes him by the shoulders. There is something Bilbo must never forget. In order to be considered safe harbor, contributions must be made within 12 months of the end of the plan year to which they relate. This means that for calendar year plans, safe harbor contributions for the previous plan year must be made by December 31 of the current year. In certain circumstances, a matching contribution must be made even sooner.

Armed with his newfound confidence and knowledge, Bilbo returns to the Shire, and amends his plan to add a QACA design. Now that he is back home, armed with Sting and with safe harbor plan provisions, he’ll never have to worry about spiders, dragons, or discrimination testing again.

If you or a client would like to be safe and sound like Bilbo, feel free to contact us about your options. After all, we ARE your ERISA solution!