If your company flunks one or more of the tests related to your retirement plan, you could indeed be charged a hefty penalty. The tests measure the average deferral percentage (ADP), the average compensation percentage (ACP), and 401(k) non-discrimination tests for failing to make the minimum contribution amounts for plans considered "top heavy."

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Does Your 401(k) Plan Need a Safe
Harbor for the Coming Year?

2. If your company flunks one or more of the tests related to your
retirement plan, you could indeed be charged a hefty penalty. The
tests measure the average deferral percentage (ADP), the average
compensation percentage (ACP), and 401(k) non-discrimination tests
for failing to make the minimum contribution amounts for plans
considered "top heavy.“
Your third party administrator should ideally steer you away from the
danger zone in time for you to make adjustments. However, if your
company seems to be flirting with the edge a little too closely, you
may want to consider adopting a safe harbor plan. Not that the
decision is a slam-dunk. A safe harbor could end up costing you more
than you would otherwise need to contribute to a plan.
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»

3. Here is a streamlined description of how
the ADP and ACP tests work, and the safe
harbor formulas (you'll need to consult a
professional for additional details).
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The ACP is similar, but looks at
employer matching contributions,
after-tax employee contributions and
certain other amounts generated by
forfeitures allocated to 401(k)
participants based on their deferral
amounts or employer matches.
The ADP test involves comparing the
individual employee deferrals of highly
compensated employees with everyone
else, also called the non-highly
compensated employees.

4. Who is Deemed Highly Compensated?
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Highly compensated employees are those who either:
1. Own at least 5 percent of the company (stock owned by
immediate family members is counted towards that 5 percent),
2. Earn at least $165,000 (amounts are adjusted annually), or
3. Own at least 1 percent of the business and earned more than
$150,000.
Learning whether you will pass or fail the ADP or ACP test requires first
determining the average deferral rate for all highly compensated
employees. Do this by adding up their total deferrals (or other amounts
for ACP testing purposes) and dividing the sum by their collective
salaries.

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Next, the same exercise is performed for the non-highly compensated
employees. These comparisons can be made either by:
• using the current year for both employee groups, or
• by comparing the prior year non-highly compensated average
deferral rate with the current year highly compensated deferral.
This method makes it easier to calculate the necessary corrective
action if your current trajectory would cause you to fail the test.

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Here are the limits:
• If the average deferral for non-highly compensated employees is 2
percent or less, the average deferral for highly compensated
employees cannot be more than twice that of the rate for non-
highly compensated employees.
• If the deferral rate of non-highly compensated employees is
between 2 and 8 percent, the highly compensated employees'
maximum average must not be more than 2 percent higher than
this (for example, if the non-highly compensated average deferral
rate is 5 percent; the highly compensated average cannot exceed 7
percent).
• Finally, if the deferral for non-highly compensated employees
exceeds 8 percent (which is unlikely), the deferral for highly
compensated employees cannot exceed it by more than 25
percent (in other words, the highly compensated rate must be no
more than the non-highly compensated rate multiplied by 1.25).

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Highly Compensated Employee Compensation Test Limits
Note: The amount of compensation for highly compensated employees
which can be counted in the test is limited to $250,000 for 2013. This
means if you defer 5 percent on a $350,000 salary ($17,500), it would
be counted as a 7 percent contribution since $17,500 is 7 percent of
$250,000. Also, the additional $5,000 in "catch-up" contributions for
participants over 50 isn't counted for testing purposes.

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Many 401(k) plans, especially those with
employee turnover, are deemed "top
heavy" by the IRS. A top heavy plan is
generally one in which the assets of "key
employees" (similar to highly compensated
employees) exceed 60 percent of the
plan's total assets. Top heavy plans must
contribute as much as 3 percent of non-
highly compensated employee salaries to
their 401(k) accounts.
Having your plan conform to the safe harbor rules lets you avoid the
testing. Using a safe harbor formula generally makes the most sense for
top heavy plans or plans which often fail the ADP/ACP tests.
Generally you must adopt the safe harbor design requirements prior to
a new plan year (with an exception noted below).

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Safe Harbor Formula Choices
You have two alternative safe harbor requirements to choose from. One
is based on your deferral matching formula, and the other, a non-
elective contribution to all plan participants.
The non-elective contribution option requires at least a 3 percent
contribution to all plan participants, regardless of whether they are
currently putting in any of their own money. (Note: That's the same
requirement for top heavy plans.) That contribution amount is not pro-
rated for employees who join the plan after the beginning of the plan
year. This means an employee with a $50,000 salary who joins the plan
in at the beginning of the 12th month of the plan year would get the
same $1,500 as a long-tenured participant.

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Under the alternative matching contribution formula safe harbor (which
of course only helps employees who are putting their own funds into
the plan), you have two choices:
1.Match 100 percent of the first 3 percent of deferrals and 50 percent
of the next 2 percent of deferrals, or
2.The "enhanced match" option. This consists of a minimum dollar-for-
dollar match on at least 4 percent of pay (or 6 percent to avoid penalty
if you failed the ACP test).

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If you aren't sure whether you want to go the safe harbor route, you
can declare 30-90 days before the beginning of the next plan year that
you might opt to become a safe harbor plan in the coming year. But if
you then decide to do so, your only formula choice is the 3 percent non-
elective deferral amount. Be sure to declare your intention to the IRS
and employees within the stated time frame, 30-90 days prior to the
end of the plan year.
The IRS website contains a useful page featuring a 401(k) "fix-it guide"
that describes remedies for a variety of compliance issues, including
screw-ups in performing ADP/ACP and top-heavy tests.

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