Safe Harbor vs. Traditional 401(k) Plans: Which One Is Better for Your Small Business?

Updated: June 20, 2023
by Cristian Morales

Deciding on the right retirement plan can feel like navigating a maze, but it doesn’t have to be. Remember, these plans are not just another item on your to-do list. They can be the key to unlocking a secure future for your hard-working team while offering tax benefits for your business. 

Before we get into the nitty-gritty, let's shine a light on an alarming trend. Despite the existence of retirement plans, there's a significant retirement savings gap in the US. A report by AARP reveals that a staggering 46 million workers earning $50,000 or less, and 11 million workers earning $50,000 or more, lack access to a workplace retirement plan.

However, not having the right 40(k) plan can seriously impact your ability to retain employees. Now, let's dive into two popular options—the traditional and the safe harbor 401(k).

Safe Harbor vs. Traditional 401(k) Plans: Which One Is Better for Your Small Business

Understanding Traditional 401(k) Plans

A traditional 401(k) plan allows employees to contribute a portion of their pre-tax salary to a retirement account. The employer also has the option to match these contributions up to a certain percentage. However, these plans require annual non-discrimination testing, which ensures the benefits are not skewed too heavily in favor of highly compensated employees.

While the traditional 401(k) plan offers flexibility in the structure of the employer's contribution, the administrative burden and complexity of non-discrimination testing can be a challenge, especially for small businesses.

Furthermore, if a traditional 401(k) plan fails to pass the non-discrimination test, highly compensated employees may face restrictions on their contributions. This limitation could hinder their ability to maximize their retirement savings potential, which may, in turn, affect their financial security during their retirement years.

Deciphering Safe Harbor 401(k) Plans

The safe harbor 401(k) plan is popular among small businesses due to its ease of administration. This plan automatically passes non-discrimination tests if it includes certain safe harbor provisions, such as a minimum safe harbor contribution to employees and immediate vesting of employer contributions.

Non-elective or matching contributions, or a mix of both, are the options available that employers can choose. In fact, safe harbor 401k plans are particularly advantageous for family-owned enterprises, low 401(k) participation corporations and business owners seeking to save taxes. 

The Secure Act 2.0 provides tax credits that may cover up to 100% of employer costs and up to $1,000 of employer contributions for the first few years. Despite the mandatory contributions, these plans can offer tax savings, help attract and retain employees, and simplify administration by avoiding the hassle of nondiscrimination testing.

Comparing the two types of 401(k) plans

When choosing between a safe harbor and a traditional 401(k) plan, small businesses should consider their financial capability, administrative resources, and the retirement goals of their employees. A safe harbor 401(k) may be ideal for businesses with a proportion of highly compensated employees who wish to maximize their contributions without the risk of failing nondiscrimination tests. However, they must be prepared for the mandatory contribution requirement.

Comparing the two types of 401(k) plans

Alternatively, a traditional 401(k) might be more suitable for businesses that prefer flexibility in their contribution structure and can manage the administrative demands of nondiscrimination testing. Consulting with a financial advisor or retirement plan expert can provide valuable insights into which plan would best serve the business and its employees.

Bottom Line

Choosing the right retirement plan is a big deal. It can shape the future of your business and your employees for years to come. By understanding the differences between the safe harbor and traditional 401(k), you can make an informed decision that aligns with your business goals and supports your team's retirement savings efforts.

Whether you opt for a safe harbor or a traditional 401(k) plan, the priority is to align your chosen plan with your business objectives. Professional advice can go a long way toward helping you understand the implications of each choice and make the best decision for your business.

So, what's your next step? Are you going to stick with the traditional 401(k) or embrace the simplicity of the safe harbor 401(k) plan? Whatever your choice, remember—you're not just making a business decision; you're shaping the future of your team.

About the author 

Cristian Morales

Freelance writer and graphic designer with a can-do attitude. I became independent after spending 6 years in the hospitality industry and 5 years in banking & finance. I'm an all-rounder guy, open to working with like-minded people.

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