Top Heavy 401(k) Plans

What does “Top Heavy” mean?
A retirement plan is top heavy if more than 60% of the plan’s assets are attributable to Key Employees. In determining this ratio for any plan year, the calculation is made as of the last day of the immediately preceding plan year.

Who are Key Employees?
Key Employees are defined in §416 of the Internal Revenue Code. Without going into all the details, the employees who meet the following criteria in the current year are usually Key Employees:

• Officers earning more than $160,000. (Was $150,000 in 2008)
• Any employee owning more than 5% of the company
• Any employee owning more than 1% and earning over $150,000 annually (not indexed)

Note, that when determining an employee’s ownership interest in the Company, the Internal Revenue Code generally considers all stock owned by the employee AND his or her spouse, parents, children or grandchildren. This means that children working in a business owned by one or both of their parents are considered Key Employees, even if they own no stock directly.

What happens if my plan is Top Heavy?
If a plan is top heavy, it must meet special minimum contribution and vesting requirements:

Contributions: A top-heavy plan must satisfy minimum contribution requirements for non-Key Employees each year. For a defined contribution plan (such as a 401(k) plan) the minimum contribution is the lesser of:

• 3% of Compensation
• The highest percentage contribution made for a Key Employee (including their salary deferral contributions)

In most cases, this means if a Key Employee participates, the Company must be prepared to make a 3% minimum contribution each year on behalf of all non-Key Employees who are eligible to participate, regardless of their election to make salary deferral contributions. This minimum contribution is over and above any employee 401(k) salary deferrals and matching contributions made for non-Key Employees. Please note that matching contribution will be counted towards the 3% minimum contribution for the plan years starting in 2002.

Vesting: A top-heavy plan’s vesting schedule must be at least as rapid as the following, of course; of course, more generous schedules are permitted:

Special Rules

• When determining whether or not a particular plan is top heavy, all qualified retirement plans sponsored by the Company must generally be considered, including plans, which have been terminated and distributed in the prior five years. If, when aggregated together, the plans are top heavy, then all plans of the Company are top heavy and must meet the minimum vesting requirements. The minimum contribution requirements must be met by a least one plan.
• When determining top-heavy status, distributions made in the preceding five years must be included.
• Rollovers from plans of unrelated employers are generally not counted in determining top-heavy status.
• Rollovers from plans of the same or related employers usually are counted in determining top-heavy status.
• If one of the employer’s plans is an ongoing defined benefit pension plan, the minimum benefit in that plan is a 2% benefit accrual per year of top heavy service, up to 10 years maximum. Alternatively, the minimum can be met by making a defined contribution minimum contribution of 5% percent, instead of the normal 3% percent.

Conclusion
401(k) plans frequently become top heavy due to the existence of another retirement plan, or a terminated or transferred defined benefit plan. If a 401(k) plan is top heavy and Key Employees make elective salary deferral contributions to the plan, the Company must make the top-heavy minimum contribution, usually 3% of compensation for non-Key Employees. This contribution is over and above the non-Key Employees’ own salary deferral and matching contributions. Failure to make this contribution will result in the plan being disqualified.

The 3% minimum contribution can be avoided if no contributions are made on behalf of Key Employees, and there is no ongoing defined benefit pension plan.

If the top-heavy minimum contribution will be made, it can serve as “dual purpose.” It will satisfy the top-heavy rules, and it may also be considered a Qualified Non-Elective Contribution (QNEC) or “fail-safe” contribution to help the plan pass its ADP test.

Alternatively, it can serve a dual purpose by providing a base contribution to all employees in an “integrated” profit sharing contribution allocation. The 3% contribution can be made as a profit sharing contribution, and the Key Employees may also receive a 3% contribution. If integrated, employees earning over the FICA wage base may be eligible to receive an additional contribution of 3% of their compensation over the wage base.

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