Retirement
plans have been subject to "top heavy" rules for about 25
years. By now you’d think that their application would be
fairly straightforward. But lately these provisions have
affected some plans in unexpected ways, surprising plan
sponsors who thought top heavy was a non-issue for their
plan. This is due in part to regulations which exempt some
plans from the top heavy requirements but only if certain
conditions are met.
What follows is a close-up look at the top heavy rules
and what can be done to avoid some unwelcome consequences.
Top Heavy Defined
A plan is considered top heavy if more than 60% of the
benefits under the plan belong to "key employees" as of the
applicable determination date. Multiple plans of an employer
in which a key employee participates must be aggregated to
form a top heavy group. Plans of the same employer not
covering a key employee can also be aggregated as part of
the top heavy group under certain circumstances.
Key Employees
The classification of key employee is sometimes confused
with "highly compensated employee" (HCE) which is used for
nondiscrimination purposes. In fact, the definitions are
similar in some respects, and while most key employees are
HCEs, many HCEs are not key employees.
A key employee is an employee who at any time during the
determination year was:
- An owner of more than 5% of the employer;
- An owner of more than 1% of the employer with annual
compensation in excess of $150,000; and
- An officer of the employer with annual compensation
exceeding a specified dollar amount, adjusted for
cost-of-living ($150,000 for 2008).
Stock attribution rules apply in determining ownership
for key employee purposes. An employee is considered as
owning the stock or interest owned by his spouse, parents,
children and grandchildren.
The number of officers who can be considered key
employees is limited to the greater of (a) 10% of the total
number of employees, to a maximum of 50 officers, or (b)
three.
Top Heavy Determination
The date for determining if an ongoing plan is top heavy
is generally the last day of the preceding plan year
(determination year). For the initial year of a plan the
determination date is the last day of the first plan year.
In defined benefit plans, the present value of accrued
benefits is used to calculate if the key employees’ share
exceeds 60% of the total. In defined contribution plans, the
participants’ total account balances are used to perform the
test. Vesting is not considered in top heavy calculations.
Certain adjustments must be made to the accrued benefits
or account balances when performing the top heavy test. The
following items must be included:
- Outstanding balances of participant loans;
- Related rollovers, e.g., from another plan previously
maintained by the same employer, and unrelated rollovers
received prior to 1984;
- Distributions during the determination year to
participants who terminated employment that year;
- In-service distributions during the five-year period
ending on the determination date to those still employed
as of the first day of the determination year;
- The cash surrender value of any whole life insurance
policies in the plan; and
- Salary deferrals and required employer contributions
for the determination year that are deposited after the
determination date. For the first plan year accrued
discretionary contributions are also included.
The following items are not included in the top heavy
test:
- Benefits of prior year terminees (those who did not
perform an hour of service during the determination year);
- Distributions to prior year terminees;
- Benefits of former key employees (those who were key
employees but are now classified as non-key employees in
the determination year). The same holds true for any
amounts distributed to former key employees; and
- Unrelated rollovers received after 1983.
Requirements of Top Heavy
Plans
Top heavy plans must provide certain minimum accrued
benefits or contributions to non-key employees and meet
special vesting requirements. These provisions do not apply
to union employees.
Minimum Benefits or Contributions
The minimum benefit in a defined benefit plan is a life
annuity at normal retirement age of 2% of average
compensation for each year of service up to a maximum of 10
years (a maximum required benefit of 20% of average
compensation). It must be provided to each non-key employee
who is credited with at least 1,000 hours of service during
the plan year. Frozen defined benefit plans are no longer
required to provide top heavy benefits.
For defined contribution plans, the minimum contribution
is the lesser of 3% of compensation or the highest
contribution rate allocated to a key employee. For example,
if the highest contribution rate for a key employee is 2%,
then the top heavy minimum contribution is 2%; if the
highest contribution rate for a key employee is 5%, then the
top heavy minimum contribution is 3%; and if no key employee
receives a contribution, then the top heavy contribution is
0%.
The top heavy contribution must be given to each eligible
non-key employee who is employed on the last day of the plan
year, regardless of the number of hours worked. An
allocation of forfeitures, derived from the accounts of
participants who terminated employment without full vesting,
is counted towards satisfaction of the minimum top heavy
contribution. The deadline for making the contribution is
the last day of the following plan year.
Where an employer sponsors multiple plans, only one plan
has to provide the top heavy benefit. Special rules apply
where an employer sponsors both a defined benefit and a
defined contribution plan.
Minimum Vesting
Top heavy plans must have a vesting schedule no less
restrictive than one of the following two schedules:
Years of
Service |
6-Year
Graded |
3-Year
Cliff |
| 1 |
0% |
0% |
| 2 |
20% |
0% |
| 3 |
40% |
100% |
| 4 |
60% |
|
| 5 |
80% |
|
| 6 |
100% |
|
Under the Pension Protection Act of 2006, all defined
contribution plans are required to use a vesting schedule no
less restrictive than one of the top heavy schedules as of
2007. Only certain defined benefit plans can still use a
non-top heavy schedule (7-year graded or 5-year cliff).
401(k) Plans
Salary deferrals under a 401(k) plan are treated
differently than other types of contributions for top heavy
purposes. Deferrals made by key employees are considered
employer contributions for purposes of determining the
minimum top heavy contributions owed to non-key employees.
However, deferrals made by non-key employees do not count
towards satisfaction of the required contribution. For
example, if any key employee defers 3% or more of his
compensation, the employer must make a 3% contribution for
all eligible non-key employees.
Matching contributions in a 401(k) plan can be used
towards satisfaction of the top heavy contribution. But such
contributions may not cover the required minimum for those
who deferred, and those who didn’t defer would be entitled
to a full top heavy contribution.
Top Heavy Exemption
A safe harbor 401(k) plan is a plan that elects to
eliminate the annual average deferral percentage (ADP) and
average contribution percentage (ACP) nondiscrimination
testing. It does so by providing either a 3% nonelective
contribution for all eligible employees or matching
contributions of at least 100% of the first 3% of
compensation deferred, plus 50% of the next 2% of
compensation deferred. An annual safe harbor notice must
also be provided.
Safe harbor 401(k) plans are automatically deemed to be
not top heavy if the only contributions to the plan are
salary deferrals and either the 3% safe harbor nonelective
contribution or the safe harbor match contribution.
Additional match contributions can also be made as long as
they meet the ACP safe harbor requirements.
Beginning in 2008, the same exemption applies to a
Qualified Automatic Contribution Arrangement (QACA), which
is a type of safe harbor 401(k) plan that utilizes an
automatic enrollment feature.
The top heavy exemption provides an added incentive for
some employers to elect safe harbor status.
Although a safe harbor 401(k) plan may be exempt from the
top heavy rules, it can still be part of an aggregated top
heavy group. In that case, employer contributions under the
401(k) plan can be used towards the contribution
requirements of the top heavy group.
Impact of Additional
Contributions
Safe harbor plans that provide additional contributions
from those mentioned above (including forfeiture
allocations) are not exempt from the top heavy rules. This
can create some surprising results.
A plan that would be top heavy if not for the exemption
would lose its exemption by making even a small profit
sharing contribution. But this contribution, together with
other employer contributions under the plan (such as the
safe harbor match), may not be sufficient to meet the top
heavy requirements. As a result, the employer might be
obligated to contribute thousands of dollars more than it
originally intended.
A similar situation can occur when forfeitures are
allocated resulting in the elimination of the top heavy
exemption. For this reason, it is wise to design a safe
harbor 401(k) plan so that forfeitures are used to offset
future contributions or pay administrative expenses.
Keep in mind that in a straight profit sharing plan
without salary deferrals, the top heavy contribution
requirement can be met simply by allocating the
contributions and forfeitures proportionately by
compensation. Then every participant would receive the same
allocation rate as the key employees. The scenario changes
in 401(k) plans due to the treatment of key employee
deferrals.
Conclusion
The increased popularity of 401(k) plans has limited the
number of retirement plans considered to be top heavy. When
a plan is top heavy it must provide certain minimum benefits
or contributions, and defined benefit plans must use one of
the accelerated vesting schedules.
Some safe harbor plans are exempt from the top heavy
requirements, but additional contributions or forfeiture
allocations to those plans can eliminate the exemption and
create further contribution obligations. Advanced planning
can help prevent some unexpected consequences and keep plans
in compliance with the top heavy rules.
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