Pros and Cons of Safe Harbor and Traditional 401(k) Plans

Traditional 401(k) Plans

Traditional plans can be cost-effective but must pass certain testing mandated by the IRS.

Pros:

Employee Incentive – A 401(k) plan is one of the most important benefits that employees look for while exploring their career options. And it comes with significant tax advantages in helping employees save for their future.
Cost-Effectiveness – Because there are no required employer contributions, traditional plans may be more cost-effective for the company.
Discretionary Contribution – Plan sponsors can decide to match employee contributions or make profit sharing contributions on a discretionary basis, which provides significant flexibility. Each year, employers can choose how much they would like to contribute, or whether they want to contribute at all.

Cons:

Required Annual Testing – Traditional plans are subject to all compliance tests, including the ADP (Actual Deferral Percentage), ACP (Actual Contribution Percentage) and top heavy determination.
Limits of Contributions for Employees – Because of the ADP test, highly-compensated employees (HCEs) may not be able to maximize their 401k contributions. If HCEs do contribute the maximum amount, and the plan fails the ADP test, required refunds may increase taxable income for certain HCEs.
Administrative Burden – The required tests and possible failures may lead to uncomfortable conversations with employees who are impacted by such failures. They will need to understand why they are receiving refunds of their contributions and may not be able to maximize their 401(k).

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Safe Harbor 401(k) Plans

Safe Harbor plans may be a better choice for employers looking for ways to bypass certain compliance tests. In return for the “safe harbor” status, employers are required to make employer contributions.

Pros:

Annual testing exemption — A safe harbor plan will be automatically deemed to pass some of the crucial compliance tests such as the ADP and ACP tests, as well as the top-heavy test.
Maximize contributions — Because they can bypass certain compliance tests, everyone in the plan can maximize their contributions to the allowable IRS limits, without having to worry about refunds.
Taxable income reduced — Employer contributions made as part of the Safe Harbor plan design are tax-deductible, reducing the employer’s taxable income.
Improved employee retention — The required mandatory employer contributions mean the 401(k) plan will be an attractive benefit to employees, which can help attract and retain talent and encourage widespread plan participation.

Cons:

Cost of annual contributions — Safe Harbor plans require mandatory employer contributions on behalf of employees. The employer must be able to provide these contributions every pay period or at the end of the plan year. Failure to do so may result in the plan losing its tax-qualified status.
Immediate vesting requirement — Safe harbor contributions must be immediately vested. Once an employer contribution is deposited into an employee’s account, the employee is 100% owner of that money.
Annual requirements — A Safe Harbor notice must be delivered to all plan participants every year, at least 30 days prior to the plan year-end.

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Which to choose: Traditional or Safe Harbor 401(k)?
	Traditional	Safe Harbor	Explanation
Employee Count	30 + employees	< 30 employees	With few employees, even a small number of HCEs contributing at a relatively high level may make it difficult for plans to pass testing. In addition, the required employer contribution may be more manageable.
Employee Demographic	Employee base consists largely of full-time employees; Low turnover rate Stable headcount	Employee base includes a large number of part-time and/or seasonal employees working <500 hours a year Part-time/seasonal employees are excluded from the plan	Safe Harbor plan design is helpful if the employee base is more fluid, which may make it more difficult to ensure the plan will pass testing each year.
Participation	High (current or expected) participation and contribution rates among the general employee population	Owners and officers looking to maximize 401(k) contributions every year	With Safe Harbor, owners and officers can maximize contributions without having to worry about potential refunds.
Company Cash Flow	Less predictable cash flow year over year	Consistent and adequate cash flow	Since Safe Harbor plans require employer contributions, consistent and adequate cash flow is needed.
Previous Compliance Result	Passed ADP/ACP Test Deemed not “Top Heavy”	Failed ADP/ACP Test Deemed “Top Heavy”	Safe Harbor plan design bypasses certain compliance tests, so “failing” them is no longer a concern.
Current/Future Plan Design	Lenient or no eligibility requirement Automatic enrollment with a high default rate	Strict eligibility requirements (i.e. must work 1,000 hours in 12 months to become eligible); No automatic enrollment (or if offered, low default rate)	NHCEs contributing at relatively low contribution rates (or not contributing at all) do not cause issues under Safe Harbor plan design.

The “right” plan for any given organization depends on many factors. The table above provides some insight into which plan design may be more helpful for any given factor, but each organization will need to make its own determination. Betterment is happy to assist with this process.