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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