A big new break for pension plans. But act fast

September 4, 2000

You have until Oct. 1 to sail your practice's 401(k) into a regulatory "safe harbor" for 2000. For 2001, the deadline is Dec. 1.


A big new break for pension plans. But act fast!

Jump to:Choose article section... How a traditional 401(k) plan can cause problems What is the safe harbor, exactly? How does the safe harbor help? Drawbacks, limitations, and complications A lot of timing options—and opportunities

You have until Oct. 1 to sail your practice's 401(k) into a regulatory "safe harbor" for 2000. For 2001, the deadline is Dec. 1.

By Brad Burg
Senior Editor

For years, the 401(k) has been the videocassette recorder of retirement plans: a great idea, but one with so many complicated options and settings that things can easily go haywire.

Suppose, though, that you could get a streamlined, user-friendly model. Guess what? You can. The improvement was actually available last year, but it wasn't clear until recently that the regulatory bugs had been worked out. Now, however, the simplified 401(k) is considered a very viable option by many experts.

A quick review of 401(k) basics: As with most plans doctors have today, the maximum annual contribution for an individual is $30,000. But with the 401(k), each participant can personally contribute up to $10,500 of that, which helps you by decreasing the amount your practice must contribute. This can get complex, though, especially since the whole package is bundled with complicated antidiscrimination tests controlling physicians' participation relative to that of staffers. The results could be unpredictable. "Sometimes, if one staffer leaves, every doctor's contributions might be cut back by thousands," says Tom Koch, a plan consultant with Clayton L. Scroggins and Associates in Cincinnati.

However, a simplified "safe harbor" version of these plans promises the 401(k) advantage without its testing and uncertainty. Moreover, setting up such a plan can be relatively simple, and your financial obligations as an employer needn't be onerous. "We've been converting many 401(k)s into safe-harbor form," Koch says. "Doctors find them easier to work with. Staffers often like them, too, because they're not hard to understand."

If you suspect you could improve your own situation, the safe-harbor 401(k) is worth considering. Many physicians can benefit, including some whose current plans are about as useful as a VCR flashing "12:00" endlessly. "Last year, the five doctors in one large practice didn't put a dollar into their 401(k), because the rules made their staff costs so high," says attorney David Schiller, of Norristown, PA. "So each physician missed a chance to put away the $30,000 overall individual maximum and needlessly paid about $10,000 in income tax. With the safe-harbor 401(k), though, staff costs will drop $50,000 to $100,000. Every doctor will contribute, and each will come close to putting away the individual maximum, too."

Now's the time to acquaint yourself with this option, because if you decide to set it up for this year or next, you'll have to act fast to meet the deadlines, as we'll see later. First, let's find out what the story is.

How a traditional 401(k) plan can cause problems

To clarify how the safe-harbor 401(k) could help you, we'll start with a closer look at how doctors' traditional 401(k) plans could hit choppy waters. For most doctors, the main challenge is how to maximize contributions for themselves without pushing staff costs sky high, so we'll run through a high-end example.

Let's assume you have a solo practice, you earn the most that you can currently base a retirement plan contribution on—$170,000—and you want to put away that $30,000 maximum amount. That's almost 18 percent of salary. A 401(k) is considered a profit-sharing plan, which means the maximum deductible contribution is 15 percent of compensation. However, the dollars need not be allocated on a pro rata basis; some participants can get more than 15 percent, some less.

How do you shift the allocation in your favor? Two factors can help. First, as we've already noted, you might contribute $10,500, the most an individual can currently put into a 401(k). That would leave only $19,500 to be put in by your practice, which could then put in less for your staffers. Also, your practice can "integrate" the plan with Social Security. Since those who earn less get proportionately more out of Social Security than high earners, integration allows contributions to private plans to be adjusted in your favor.

Results? You get your $30,000. Your individual contribution totals a bit over 6 percent of your salary; the practice contributes over 11 percent for you. Your staffers get about 8 percent, says Koch.

So far, not bad. But the dollars you contribute yourself are the key to the whole strategy, and a mandatory 401(k) "test" for such individual contributions may hamper you considerably. The average individual contributions of staffers must be compared with the average for doctors, and what the staffers do can hold the doctors back.

"For example, if staffers' individual contributions average 2 percent of compensation—a fairly common figure—the doctors' individual contributions can't average more than 4 percent," says Megan Kommer, a consultant with Thomas, Doll & Co. in Walnut Creek, CA. So your boat gets rocked: The most you can put in personally drops from $10,500 to $6,800. Then you have to rely more on your practice's contributions. To hit $30,000, your practice must put in $23,200 for you. That's 13.6 percent of your $170,000 income. Your staff costs, even with integration, will rise to about 10 percent.

True, you can encourage staffers to increase their individual contributions by offering to "match" those, to some extent, with dollars from your practice. Matching is a crucial feature that can make 401(k)s work, but it also increases your costs. It requires more plan testing, too, to make sure your matching formula doesn't favor the doctors. More headaches, more administrative expenses.

Worst of all, one person can pretty well capsize your entire arrangement. "Sometimes a practice's 401(k) is going along fine, because one staffer is contributing a high amount, like 10 percent of income," says Koch. "Then that employee leaves, the staffers' average contribution plummets, and as a result, all the doctors' contributions may be cut back—from $30,000 to $25,000, or even lower." Or, to prevent that, the practice must contribute thousands more for staffers.

With a traditional 401(k), then, smooth sailing is hard to achieve and impossible to assure.

What is the safe harbor, exactly?

Not surprisingly, many doctors and other small employers have avoided 401(k) plans because they're so complex and often unpredictable in a small-group context. That's why, to encourage participation, the government provided the simplified safe-harbor alternative. You can avoid the 401(k) testing if your practice chooses one of two safe-harbor options:

  • It contributes 3 percent of compensation for all staffers.

  • It contributes matching dollars, based on the percentage of compensation employees put in.

Typically, the matching occurs in two steps: The practice fully matches all employee contributions up to 3 percent of compensation, then matches half of the next 2 percent. (However, you can opt for an "enhanced" matching variation that lets the practice base the match on up to 6 percent, so long as your formulas don't favor doctors over staffers.)

Which is better: the 3-percent-across-the-board option, or matching? Most consultants we spoke with favor the first choice. Not only is it simpler, it may cost nothing extra, because your practice may already be obligated to contribute 3 percent, anyway. To see why, let's briefly look at a general rule that affects many plans. It's called the top-heavy rule, and it kicks in when at least 60 percent of the dollars in a plan's accounts belong to participants who each own more than 5 percent of the business. In such cases, the employer must contribute 3 percent for all staffers.

"This rule applies to most physicians' plans," says actuary and plan consultant John Maloney, of Schaumburg, IL, "and the same 3 percent is allowed to perform double duty, fulfilling the obligations of both rules."

If you opt to match participants' contributions, however, that's not the case: The matching dollars you put in can't apply toward that top-heavy obligation; they're in addition to it.

Should you forget about matching, then? Not necessarily. Remember, the matching dollars depend on what participants put in. If staffers don't contribute much but doctors do, then most matching dollars may go to physicians. In that case, you could come out ahead with matching (see below).

How does the safe harbor help?

To sum up: You'd be free to make your individual contribution, up to that $10,500 maximum for a 401(k) plan, simply by meeting one of two relatively straightforward requirements. You needn't be concerned about what employees do or don't do. "Moreover, your practice's cost to cover employees might be just 3 percent," notes Koch. "And that 3 percent can help the doctors, too, since it can be contributed for them, as well."

Let's say you earn $120,000 and put in $10,500 yourself. With the 3 percent your practice can put in for you, contributions for you would total 12 percent. Couple that with the administrative simplicity of the safe-harbor 401(k), and you see why it appeals to many physicians.

The safe-harbor choice may also allow you to boost the benefits you get from matching, attorney Schiller notes, since your plan won't have to pass any tests in that area. "Let's say it turns out that with a safe-harbor plan, you and the other doctors are indeed free to make large individual contributions, up to the $10,500-per-person 401(k) cap. In that case, instead of the minimum safe-harbor match, you might offer to base matching on the 6 percent maximum allowed," he says.

We've focused on high earners' figures to emphasize the essential retirement plan problem: how to get enough into your plans, on your own behalf. But safe-harbor 401(k)s can help in a range of situations.

In one such case, Kommer consulted with a young two-physician couple who'd been using a very basic plan option called a SEP-IRA for themselves and three staffers. "Individually, they weren't high earners," Kommer says. "Each was in the $120,000 range. They'd been independent contractors, but they'd recently set up their own office and were inclined to stick with the simplest plan."

The numbers changed the doctors' minds: "They'd been putting away $18,000 each. With a safe-harbor 401(k), we found that they could raise that to $30,000 apiece—and their staff costs only crept up from $3,300 to $3,600." To make the percentages work out right, they even had to add a simple second plan in which contributions were limited to a fixed percentage of earnings. "They had to spend about $2,000 to set all this up, and they'll have $1,500 annual administrative fees that they didn't have before. But even with those extra costs, they're still way ahead," Kommer says.

She notes, though, that the safe harbor may not be the best choice for doctors who are high-earning, older, or both. "Many plan designs favor older participants, sometimes powerfully," she says. "But the safe-harbor plans ignore age, which can make them a better choice for younger doctors."

David Schiller has seen the safe harbor provide a solution at the other practice extreme—in that large practice described earlier, where staff costs were so heavy that the doctors had chosen to contribute nothing to their 401(k). "This is a large FP group with five doctor-partners and 26 employees, including two young physicians," he says. "They had the classic problem: Few of the staffers participated, so the partners were prevented from putting in as much as they wanted.

"In this case, I recommended a safe-harbor plan with the matching requirement, not the 3-percent-for-everyone option," he continues. "Based on low staff participation in the past, it seemed likely that most employees wouldn't contribute much, even with matching. Most of the matching dollars, then, were likely to go to the doctor-partners."

Indeed, Schiller recommended the maximum match allowed for safe-harbor plans: 100 percent, based on up to 6 percent of compensation. "Then, just in case staffers did contribute more, I ran figures assuming they would all contribute 3 to 6 percent. But even with these assumptions, the partners still got 62 percent of the money they put in, either individually or through the practice. That's up from 47 percent. And individually, their contributions increased from $26,000 to over $28,000."

Drawbacks, limitations, and complications

All that said, should you jump on this bandwagon?

Not necessarily. Yes, the safe harbor is fairly simple, it lets you put away your individual maximum, and it provides a stable setup to permit that. However, you might not need it. "If you already have a 401(k) and you're able to make your individual $10,500 contribution without a safe-harbor plan, you probably won't need to switch," says Kommer.

Moreover, safe-harbor plans do have some potentially serious drawbacks. With many other plans, to be eligible for contributions, a participant must accumulate 1,000 hours of service or must be employed on the last day of the plan year. You can't have those rules with a safe-harbor plan, so you might have to contribute for more employees. On top of that, in the safe-harbor 401(k), employees' rights to those dollars you contribute for them vest immediately.

"Doctors' plans generally do impose such service requirements before contributions must be made—and even if they are made, they usually vest only gradually, over several years," notes Judy Soled, a plan administrator in Westlake Village, CA. "Medical practices often have high turnover, so those restrictions are reasonable."

They can prove significant too, Soled notes, because in plans with vesting requirements, unvested amounts left by departing workers may grow to a considerable amount. That money is ultimately distributed to the remaining participants, or you can use it to reduce current contributions, in some cases. Since you lose those savings opportunities with a safe-harbor plan, it can increase your plan's cost.

If you already have another retirement plan, you've got to consider its role, as well. "Plans that favor older participants—especially 'new comparability' plans, a particularly flexible type—often give doctors big advantages," notes Kommer. "So we checked whether new comparability and a safe-harbor 401(k) would work together for our clients." She generally found that they wouldn't. New comparability (also called "cross-testing") is so powerful, Kommer says, that by itself it will beat even safe-harbor 401(k)s in situations where most physicians are older, and maybe in other settings, too.

"In most cases we looked at," she says, "the client's existing plan was already helping doctors so much that it wasn't worth the trouble to create a two-headed monster. Sometimes, too, certain 401(k) rules would have created conflicts." Still, your situation might differ enough to make the safe-harbor option viable, so it pays to investigate before making your decision.

Staffers' reactions could be another sticking point. Generally, employees tend to like 401(k)s, because the plans typically allow them so much decision-making and control. They have some choice in how much salary to defer into the plan, and sometimes even how to invest it. Also, the employer may offer matching dollars, on top of a basic contribution for employees. Still, if you switch into a safe harbor from another kind of plan, including a regular 401(k), employees may get less, and that's certainly a point to consider carefully. So proceed with caution, and leave the explanations to plan designers and administrators, who know how to present this in the most accurate and positive light. They can explain, too, that with the economic pressures affecting many practices today, sometimes the alternative is no plan at all.

A lot of timing options—and opportunities

If you're at all interested in the safe-harbor plan possibility—even if you're not certain about it—you need to be alert to some deadlines:

  • If you have no plan at all, you can set up a safe-harbor plan for this year, provided you notify employees by Oct. 1.

  • The same cutoff holds if you have a profit-sharing plan that's not a 401(k) and want to convert it.

  • Assuming you already have a traditional 401(k), it's too late to turn it into a safe-harbor version for this year. Next year's deadline is approaching, too: You have to notify eligible employees by Dec. 1 of this year.

Not sure you'll want to make the change? You could send a notice just to keep the option open. You need only say your plan may convert to the safe-harbor type next year. Any drawbacks? "You might get employees' hopes up prematurely, especially if they're looking forward to that immediate vesting," notes Marge Paul, an actuary with Reish & Luftman. That may seem a small risk, though.

If you do then convert, you'll have to give a written notice of that during the plan year. You can even switch out of a safe-harbor plan during a plan year. "Late in the year, you might see that staffers are contributing enough so that you'll pass the usual 401(k) tests," says John Maloney. "At that point, you may decide you prefer the old-fashioned style, with its old-fashioned vesting rules."

Whew. Nobody ever said working out the most effective retirement plan would be easy. The safe-harbor 401(k) may be well worth the effort, though, because it could save you thousands in staff costs. It could also mean a more secure retirement for you. Now's the time to look into it.

What does a safe harbor look like?

Attorney David Schiller of Norristown, PA, provides the following illustration of how a safe-harbor 401(k) could help doctors with their plans.

An ordinary profit-sharing plan lets a practice put away 15 percent of total payroll, and in the example below—for an FP soloist—that's $41,505. How much of that is the doctor's? Plan rules say the one-person limit is $30,000, and this high-earning physician wants to reach it. But 15 percent of his own compensation is just $25,500. Actually, he gets somewhat more, because his plan increases allocations for higher earners, to "integrate" with Social Security (which also benefits lower earners more, proportionately).

Still, he can do better. Adding a traditional 401(k) option would permit individual contributions, so the doctor could put in $6,800. His practice's contribution for him would then drop greatly, which would reduce what the practice must put in for staffers, too (see the "Employer contribution" column). He'd do even better for himself by contributing the individual 401(k) maximum of $10,500, but the rules would hold him back, based on low individual contributions by staffers, which average about 2 percent. He could, however, put in more of the practice's money by "matching" employee contributions, including his own. His share of contributions made by him and his practice would rise from 66 to 76 percent.

A safe-harbor 401(k) would help him even more. With it, the doctor could put in $10,500, regardless of what employees put in. To do so, he could either give everyone 3 percent across the board, or match a portion of employees' contributions. Here he uses the second choice, and his share of the plan dollars reaches 83 percent.

Based on these reasonable projections about employees, matching can work. But many experts recommend the flat 3 percent approach, because it doesn't depend on employee behavior. "Matching can cost you more, if employees respond with larger individual contributions," says Megan Kommer, a plan consultant with Thomas, Doll & Co. in Walnut Creek, CA.


Plan type



Employee contribution

Employer contribution

Employer matching


Percent to doctor2

Non-401(k) profit-sharingDoctor$170,000N.A.$27,562N.A.$27,562
 Staffer 144,777N.A.5,851N.A.5,851
 Staffer 230,229N.A.3,950N.A.3,950
 Staffer 331,694N.A.4,142N.A.4,142
 Staffer 144,7771,7912,8701,7916,452
 Staffer 230,2296051,9386053,148
 Staffer 331,69402,03202,032
 Staffer 144,7771,7911,5781,7915,160
 Staffer 331,69401,11701,117

1The doctor could be earning more than $170,000, but an individual’s contributions are calculated on that figure, at most. 2The percentage of the money the doctor paid—personally as well as through his practice—that ends up in the plan for his benefit. N.A.: not applicable.



Brad Burg. A big new break for pension plans. But act fast. Medical Economics 2000;17:60.