Government agencies require annual non-discrimination testing for company-sponsored 401(k) plans to prevent benefits from disproportionately favoring certain employees. These tests compare voluntary contributions from highly compensated employees (HCEs) with those from non-highly compensated employees (NHCEs).
Who Qualifies as an HCE?
The IRS defines HCEs as:
- Employees owning >5% of the business, or
- Employees earning ≥$130,000 annually (2023 threshold; adjusted periodically).
Companies may adopt stricter internal definitions if no employees meet IRS criteria.
Consequences of Failing Tests
If HCE contributions dominate, the plan fails. Remedies include:
- Refunds to HCEs, or
- Corrective contributions to NHCE accounts.
Repeated failures risk plan disqualification—eliminating tax-deferred status for all participants.
The Safe Harbor Alternative
Convert to a safe harbor 401(k) to bypass annual testing entirely. Employers fund guaranteed contributions that vest immediately, while employees retain full deferral rights.
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What Is a Safe Harbor 401(k)?
Safe harbor plans satisfy IRS non-discrimination rules by design, eliminating annual compliance tests. Employers commit to formula-based contributions—100% vested on deposit—regardless of employee participation.
Conversion Process
- Partner with your 401(k) provider: Most support safe harbor designs (often at lower admin fees).
- Issue IRS-mandated notice: Deliver written details 30–90 days before the plan year, explaining:
- New contribution formulas
- Employee eligibility
- Impact on existing balances
Any traditional 401(k) can switch mid-year with proper timing and documentation.
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Types of Safe Harbor Plans
| Plan Type | Employer Contribution Formula | Key Notes |
|---|---|---|
| Non-Elective | 3% of compensation to every eligible employee | No employee deferral required |
| Basic Matching | 100% match on first 3% deferred + 50% match on next 2% deferred (Max employer: 4% of pay) | Total cap prevents excess for high deferrers |
| Enhanced Matching | ≥100% match on first 4% deferred (e.g., dollar-for-dollar up to 4%) | Simplest; often most attractive to employees |