#8: A safe harbor retirement plan is better for employees.
All retirement plans should be safe harbor.
Because my company doesn't have one, I'm losing out on $12,263 per year.
How did I find myself spending precious time reading retirement plan law?
In 2016, my salary was just shy of $120,000. In 2017, a small 2.25% raise put me just over. Ironically, that $2,700 raise cost me $9,411 in pre-tax 401(k) deferrals. And since I’m now able to defer $9,411 less per year, I pay an extra $2,852 in income tax. In total, I’m $12,263 worse off, and all over a $2,700 raise and a previously unknown-to-me retirement plan provision called Safe Harbor. My retirement plan doesn’t have it.
My new CPA was baffled. “I’ve never heard of a big company like Moda not having a safe harbor plan.” She shook her head. “It’s terrible. You’re too young not to contribute the full amount to your retirement plan. Can you get a different job?” I appreciate the frankness of my new CPA. She’s right—I am too young not to contribute the full amount to my retirement plan. But is getting a new job my only option? And what put me in this position to begin with?
What's so great about safe harbor retirement plans?
Safe harbor plans require employer contributions to be equal between all employees and to be immediately vested. Practically speaking, this means employer contributions can’t vary by employee title, salary, or length of service. General staff gets the same contribution as the executive team. Customer service representatives making $45,000 get the same contribution as an IT manager making $150,000. And an employee who’s been with the company 1 year gets the same contribution as an employee who’s celebrating her 10-year anniversary. Because employer contributions are immediately vested, employees that leave the company can take 100% of the employer contributions with them, even if they’ve only been at the company 1 year.
Traditional 401(k) plans are the complement. They can include employer contribution schedules that vary by employee title, salary and/or length of service. At my company, the contribution increases with tenure. Employees with 1-4 years of service get 3% + 2% match. That increases to 3% + 4% match for employees with 5-9 years of service, then 3% + 6% match for those with 10 or more. Traditional 401(k) plans can also include a vesting schedule, meaning ownership of employer contributions has to be earned over time. An employee has to work for more than 6 years at my company to be fully vested. A new hire that left after 2 years would only be able to take 20% of the employer contributions with them.
The other major difference is that traditional 401(k) plans are subject to non-discrimination testing. Non-discrimination rules are a good idea in theory, and are designed to make sure a special class of employees called Highly-compensated Employees (HCE’s) aren’t favored by the company’s retirement plan. Who is an HCE? Me, or rather any employee making $120,000 or more. Also employees with more than 5% ownership in the company, and “key” employees as defined by the IRS. The result of non-discrimination testing is the amount an HCE can contribute to his or her 401(k) plan is limited by how much the non-highly-compensated employees (NHCE’s) actually do contribute.
Said another way, if NHCE’s contribute an average of 5% to their 401(k) plans, then to pass the Actual Deferral Percentage (ADP) Test, HCE’s are limited to contributing 7%. And that’s what happened to me this year. (There are two other tests—the Actual Contribution Percentage (ACP) Test and the Top-Heavy Test but we’ve discussed enough testing for one day.) I am an HCE, which is supposed to be a good thing, but the NHCE’s at my company only contribute an average of 5% per year. Instead of being able to contribute up to $18,000 per year, I can contribute 7% x $122,700 = $8,589 which leaves $18,000 - $8,589 = $9,411 on the table.
To compound the problem—mathematical pun intended—deferring less means I earn $9,411 more in taxable income. At my average tax rate of 32%--did I mention my new CPA also told me to move from Oregon to SW Washington to avoid the hefty Oregon state income tax?—that amounts to an additional $2,852 in income tax. Ouch and double ouch. It’s a conundrum. Surely leaving my company over retirement plan contributions—or lack thereof—is extreme, but so is missing out on thirty years of pre-tax retirement income growth. That $9,411 I can’t contribute this year is $82,393 less in income I’ll have when I retire (assuming I retire 30 years from now and earn an average annual rate of return of 7.5%.)
What else did I accidentally learn along the way?
SW Washington may not have income tax, but it has high sales tax. If I really wanted to minimize my tax liability, there are far better options than Vancouver, Washington. Maybe better is the wrong way to put it. How about cheaper? There are far cheaper places to live than Oregon and Washington. How about Wyoming? Or Alaska! Maybe one day when I’m not bound to a 60-mile radius within Portland by the terms of my Parenting Plan, I’ll consider a move. For now, I’m just going to update my resume and consider my job options.
What were my sources?
Websites like Captain401.com: https://captain401.com/blog/safe-harbor-401k-plans/