Setting up a safe harbor 401k plan can prove a wise business decision for many employers. By shielding your company from nondiscrimination testing, a safe harbor plan allows employees (and employers) to maximize their retirement savings, thereby saving on taxes.
As a business owner, are you interested in offering a 401k plan to your employees? Wondering which type of 401k plan is best for your company? Concerned that you might invest the time, energy and money to set one up, then end up being the only one making contributions? Worried this means you won’t be able to meet compliance requirements and lose out on potential tax savings? These concerns are entirely valid!
It’s common for companies with “top-heavy” 401k plans to run afoul of the Employee Retirement Income Security Act (ERISA), especially smaller firms where HCEs (Highly Compensated Employees) may make up a significant portion of the staff. The safe harbor 401k was developed to alleviate this issue. Introduced by the Small Business Job Protection Act of 1996, a safe harbor 401k involves mandatory employer contributions, and when structured correctly, aren’t subject to nondiscrimination testing.
So which benefits package is better for you and your employees: a traditional 401k or a safe harbor 401k plan? Let’s dive into the details and find out…
What Is a Safe Harbor 401k?

To ensure that all employees in a company—whether it’s an entry-level administrative assistant or the CEO—can save for their retirement in an equitable manner, the IRS conducts regular 401k nondiscrimination testing. These tests ensure that company-sponsored 401k plans align with Employee Retirement Income Security Act (ERISA) requirements. Businesses that fail to meet these requirements are susceptible to costly penalties and may be forced to make corrective distributions.
Per the IRS, a company-sponsored plan is considered “top-heavy” when “key employees” own 60% or more of the assets within the plan. Key employees are defined as having:
- Ownership of 5% or more of the company
- Ownership of 1% or more of the company AND earnings of $150,000 or more annually from said company
- An income of $200,000 or more while holding an officer position
Small- to mid-sized firms risk failing nondiscrimination testing since there’s a skewed ratio of officer positions to lower-level employees. If the IRS determines your plan to be top-heavy, you’ll be required to make contributions (up to 3% of the employee’s salary or equal to the highest contribution made by a key employee, whichever is lower) to bring the plan back into balance. In short, top-heavy plans can cost you more money and potentially reduce your ability—as the business owner—to max out your own retirement savings.
A safe harbor 401k plan allows employers to bypass these nondiscrimination tests, provided you are making the minimum contributions to employee accounts. Your options here include:
- 100% match on elective employee deferrals at 3%, then 50% match on the next 2%
- 100% match on elective employee deferrals at 4%-6%
- A blanket 3% contribution for every employee, regardless if the employee has elected to make salary deferrals
It’s important to note that your safe harbor 401k plan is only exempt from testing if you are making these minimum contributions.
What Are the Major Differences Between a Safe Harbor 401k and a Regular 401k?
The major differences between a safe harbor 401k plan and a traditional 401k boil down to timing, cost, and administrative burden. Understanding these differences is imperative when deciding which plan is best for your company. But first, let’s examine the core similarities:
- Both plans have the same maximum employee deferral limit of $20,500 in 2022 (indexed annually by the IRS).
- Both also offer catch-up contributions of $6,500 for participants 50 or older (also indexed annually by the IRS), and allow for Roth contributions within the deferral limit.
- Traditional and safe harbor plans are available through many investment providers, and both are compatible with profit-sharing plans.
Unlike the traditional 401k, a safe harbor 401k must be in effect for at least three months out of a given calendar year in order to claim tax benefits for that year. In short, a safe harbor 401k has to be set up by October 1st. However, it’s important to note that such plans require you to give employees 30-90 days advance notice so they have enough time to assess the plan and decide whether or not to participate.
Safe harbor plans also differ when it comes to making mid-year changes, as explained in IRS Notice 2016-16, and there are specific safe harbor 401k rules to follow. Employees must again be notified 30-90 days before any changes to a matching safe harbor plan go into effect. This notice gives them enough time to alter their deferral percentages and process changes. Additionally, you cannot change from matching to nonelective or reduce benefits mid-year.
As noted earlier, a safe harbor 401k is only exempt from nondiscrimination testing if the employer is making the minimum contributions. A traditional 401k plan—on the other hand—doesn’t mandate employer contributions. While it’s highly unlikely to prove attractive to employees if there is no company match, you could conceivably set up a traditional 401k plan funded by worker contributions only.
What Are the Benefits of Choosing a Safe Harbor 401k?
There are many reasons to consider opting for a safe harbor 401k, especially if you’re operating a smaller company.
Employer Benefits
The most significant benefit of a safe harbor 401k plan is avoiding nondiscrimination testing. Safe harbor plans allow an employer to avoid the following tests:
- Actual Deferral Percentage (ADP) test: Determines whether or not highly compensated employees (HCEs) exceed the maximum contribution amount as permitted under nondiscrimination test rules, compared to non-HCEs.
- Actual Contribution Percentage (ACP) test: Determines whether or not post-tax contributions/employer match contributions made by or for HCEs exceed the maximum amount allowed under nondiscrimination testing rules compared to non-HCEs.
- Top-Heavy Plan Test: Determines whether or not the assets of HCEs and officers make up more than 60% of a retirement plan, thus favoring “top” employees over middle management and entry-level employees.
This is crucially important for smaller companies where the owner and other HCEs want to max out their own 401k contributions without running into ERISA compliance issues that might otherwise flag the plan as “top-heavy” and require costly corrective distributions. In other words, in a traditional 401k scenario where a business owner over the age of 50 wants to defer the maximum allowed ($27,000 in 2022), but the rest of the company employees have only contributed a fraction of that amount, the IRS will force the owner to make nonelective contributions to the non highly compensated employees. That isn’t an issue with a safe harbor 401k as it’s not subject to same ERISA requirements as a traditional 401k.
Setting up a safe harbor 401k is also an excellent way to attract and retain top talent. In a competitive industry, finding experienced and productive workers can prove a challenge. If you have a candidate you want to hire, but a competitor is offering a more lucrative company match, you’re likely to lose out. Investing in an attractive benefits package is key to employee recruitment and retention.
Finally, a safe harbor 401k offers employers major tax savings as annual contributions to the plan reduce the company’s taxable income.
Employee Benefits

A safe harbor 401k plan acts as a two-way street, benefiting both employees and employers. For starters, perhaps the most significant employee advantage of a safe harbor 401k plan is the mandatory employer contribution to retirement accounts. Employers can choose to make nonelective contributions, which are across-the-board for all employees, based on a percentage of their compensation. Or they can make matching contributions, thus incentivizing employees to defer part of their salary to their 401k. Either way, employees stand to benefit from the additions to their retirement savings.
The tax deductions associated with retirement savings still apply for safe harbor 401k plans. Employees can opt for a tax break now and take RMDs (required minimum distributions) in retirement. They’ll pay taxes (based on their tax bracket in retirement) when they withdraw funds from their 401k funds bolstered by employer contributions over the years.
Another important benefit for employees is the ability to max out their retirement savings. Because there are no testing requirements, every employee is entitled to save up to the maximum allowed by the IRS.
The final employee benefit of a safe harbor 401k plan (and another key difference between safe harbor and traditional) is immediate vesting. In a traditional plan, employer contributions go through a vesting period. Employees must work X-number of years before they have full ownership of funds. With safe harbor 401k plans, ownership immediately transfers to the employee. If they leave the company tomorrow, any money you’ve contributed to their retirement account is theirs to keep—even if they just started working for you last year.
Which Is the Better Fit? A Safe Harbor or Traditional 401k?

Both traditional and safe harbor 401k plans may work for your business. One won’t always trump the other, so understanding the pros and cons as they relate to your business is crucial. If you’re considering a safe harbor 401k plan over a traditional plan for your company, ask yourself the following questions:
- Do we have the budget to match employee contributions?
- Are we worried about failing or have we failed nondiscrimination tests?
- Do we have low participation among non-high compensation employees/key employees?
If the answer to those questions is no, you might choose to stick with a traditional 401k option. If the answer is yes, perhaps a safe harbor 401k plan is right for your company.
If a safe harbor 401k plan sounds like the best route, you must determine which contribution plan works with your budget. As noted earlier, you have three options when it comes to mandatory employer contributions:
- Basic Match Contributions: Employers match 100% of employee contributions, up to 3% of the employee’s total compensation. Then, they match an additional 50% of deferrals on the next 2% of compensation. These contributions are only available to eligible employees who actively contribute to their 401(k)s.
- Enhanced Matching Contributions: Employers match 100% of employee contributions from 4% to 6% of their total compensation. Like the basic match, these contributions only apply to those actively contributing themselves.
- Nonelective Contributions: Employers contribute at least 3% of an employee’s compensation, whether the employee elects to contribute or not. Unlike enhanced and basic plans, nonelective contributions apply to all eligible employees no matter what.
If only a handful of employees contribute to their 401k, a matching safe harbor plan may be more cost-effective. Alternatively, if everyone contributes generously to their retirement plans, the nonelective or basic matching formula could prove the better choice.
Polaris Pro Tip: It’s important to balance the cost of employer contributions against your need to attract and retain talented employees. Even if an enhanced matching contribution of 4% makes more sense financially, opting for 5% might be worth the additional spend in order to stay competitive in your industry. At Polaris Wealth Advisory Group, we can help you determine what makes the most sense for your business.
Assess Your 401k Options—Enlist a Financial Advisor Today
Setting up a safe harbor 401k plan can prove a wise business decision for many employers. By shielding your company from nondiscrimination testing, a safe harbor plan allows employees (and employers) to maximize their retirement savings, thereby saving on taxes. Seek help from trusted financial advisors, like the team at Polaris Wealth Advisory Group, to better understand your retirement benefits options.
With the right plan in place, your company can position itself to attract top talent and remain one step ahead of competitors. Get in touch with Polaris Wealth Advisory Group today to learn more about how a safe harbor 401k plan can benefit you, your company, and your employees.