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
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
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.
Top heavy plans must have a vesting schedule no less restrictive
than one of the following two schedules:
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).
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
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
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
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
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
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
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