There are many reasons for the wide popularity of 401(k) plans, one of which is that they shift the funding burden from employers to employees. But this advantage may be diminished for plans classified as “top heavy” where special contribution rules kick in that plan sponsors may not be aware of. What follows is a detailed look at the impact of the top heavy rules on 401(k) plans and some strategies for minimizing the cost to employers.
What is a Top Heavy Plan?
A defined contribution plan is considered top heavy when more than 60% of the account balances are attributable to “key employees.” A key employee is an employee who meets any of the following criteria during the determination year:
- Owns more than 5% of the employer;
- Owns more than 1% of the employer and had compensation in excess of $150,000; or
- Is an officer of the employer with compensation in excess of a specified dollar amount ($165,000 for 2012), with certain limits on the maximum number in this category.
In determining ownership, family attribution rules apply, meaning that an employee is deemed to own the stock or interest owned by his or her spouse, parents, children and grandchildren. It’s important for employers to keep their third party administrators abreast of any changes in the ownership or officer status of the company so that the top heavy tests can be performed accurately.
The term “key employee” is sometimes confused with “highly compensated employee” (HCE) which is used for nondiscrimination testing. The main difference is that HCEs include all employees earning more than a certain dollar amount in the prior year ($115,000 in 2012), whereas such employees would not be considered key employees unless they meet the ownership or officer criteria.
Most large 401(k) plans are not top heavy due to the high number of non-key employees participating.
How is Top Heavy Calculated?
For ongoing plans, the top heavy determination date is the last day of the preceding plan year (determination year). For new plans, the determination date is the last day of the first plan year. As of the determination date, the account balances, including loans, of the key employees are compared to the total account balances of all participants, without regard to the plan’s vesting schedule. Certain adjustments must be made to the account balances when performing these calculations. The following amounts must be added: distributions to recent terminees; in-service distributions over the past five years; and the cash surrender values of whole life insurance policies.
The following amounts must be subtracted: unrelated rollovers, i.e., those not coming from another plan sponsored by the same employer (related rollovers should not be deducted); and account balances of participants who terminated prior to the determination year. Account balances and distributions to former key employees are not included.
Here is an example of a top heavy plan calculation: Thomas owns 100% of ABC Company which sponsors a profit sharing plan. He and his wife both work for the company as does their 25 year old son. All three are considered key employees due to stock ownership and attribution rules. The account balances under the plan are as follows:
| Employee | 12/31/11 Balance |
Unrelated Rollovers |
Distributions to 2011 Terminees | Total |
|---|---|---|---|---|
| Thomas | $500,000 | $0 | ||
| Cindy | 100,000 | 0 | ||
| Thomas, Jr. | 50,000 | ($25,000) | ||
| Total Key | $650,000 | ($25,000) | $625,000 | |
| Non-Key | 450,000 | (100,000) | $25,000 | 375,000 |
| Plan Totals | $1,100,000 | ($125,000) | $25,000 | $1,000,000 |
| Key Percentage: | 62.50% | |||
Since the adjusted account balances of the key employees exceed 60% of the adjusted account balances of the entire plan as of December 31, 2011, the plan is top heavy for 2012.
Generally, if the employer sponsors multiple plans covering the same key employee(s), they are required to be aggregated for top heavy purposes.
Consequences of Being Top Heavy
A defined contribution plan that is top heavy must provide a minimum contribution to non-key employees equal to the highest contribution rate allocated to any key employee up to a maximum of 3% of compensation. For example, if a top heavy profit sharing plan has one key employee who received a contribution of 2% of his compensation, then all non-key employees would be entitled to a 2% contribution. If the key employee receives a 4% contribution under the plan formula, then the non-key employees must receive at least a 3% contribution.
Forfeiture allocations, as well as matching contributions in a 401(k) plan, are included and provide a dollar-for-dollar offset of the required top heavy contribution. When an employer sponsors multiple plans, the top heavy benefits need only be provided by one of the plans; however, there are special rules and potentially higher contributions that may apply when an employer sponsors both a defined benefit and defined contribution plan.
Impact on 401(k) Plans
The top heavy regulations provide that salary deferrals made by key employees are considered employer contributions but deferrals by non-key employees are considered employee contributions. In other words, deferrals by a key employee can trigger the top heavy contribution requirement, yet deferrals by a non-key employee cannot be used to satisfy the requirement.
For example, if the plan is top heavy and one key employee defers 4%, the 3% minimum contribution requirement will apply to all non-key employees who have met the plan’s eligibility requirements, even those who have elected not to make deferrals. It is important to note that for plans with multiple eligibility schedules, i.e., immediate eligibility for 401(k) deferrals and a one-year wait for company contributions, any non-key employee who is eligible for any component of the plan and is still employed on the last day of the plan year is entitled to the top heavy minimum contribution.
How to Avoid Top Heavy Contributions in a 401(k) Plan
Here are a couple of strategies that can be utilized to avoid the top heavy contribution requirement in a 401(k) plan.
Key employees can choose not to participate if the plan is top heavy. If no key employee receives a contribution or forfeiture allocation, then top heavy contributions are not required. This strategy not only serves to eliminate the contribution requirement but also is likely to reduce the key employee top heavy percentage over the years, assuming that non-key employees continue to contribute (investment results and employee terminations also play a factor).
It’s possible that after a few years of not participating, the key employee percentage will drop below 60%, resulting in the plan not being top heavy for one or more years and allowing key employees to resume participation.
Another strategy is for one or more key employees to take an in-service distribution from the plan, if allowed under the terms of the plan. This option is less effective since in-service distributions over the last five years must be added back when calculating the top heavy ratio. But after five years, such distributions are ignored, potentially resulting in the plan falling out of top heavy status for many years.
Keep in mind that in-service distributions may be unnecessary where the key employees choose not to participate because after five years of not contributing the plan may no longer be top heavy even without such distributions.
The Safe Harbor Alternative
Certain salary deferral plans that provide minimum contributions and meet an annual notice requirement are exempt from the top heavy rules and are automatically deemed to pass the annual ADP (actual deferral percentage) and ACP (actual contribution percentage) nondiscrimination tests. This only applies if additional employer contributions above the safe harbor limits are not made to the plan. Such plans may actually require the employer to contribute less than the top heavy minimum. They include:
SIMPLE 401(k) Plan
This is a good compromise for many employers with 100 or fewer employees. The employer must contribute 2% of compensation to all participants earning at least $5,000 or make a matching contribution of 100% of deferrals up to a maximum of 3% of compensation. No other contributions are allowed and all contributions must be fully vested. Participants of this plan may not receive any contributions or benefit accruals under any other plans of the employer.
SIMPLE 401(k) plans have lower contribution limits. Instead of the current $17,000 deferral limit, plus $5,500 catch-up limit for those age 50 and over, participants in a SIMPLE 401(k) plan can defer up to $11,500 plus $2,500 as a catch-up ($14,000 total).
The 2% contribution requirement is less than the 3% top heavy contribution. In plans where the employer is already making some matching contribution this might not represent a big increase. And the reduced deferral limit may actually be higher than what HCEs could defer under the ADP test. This alternative works very well for some employers.
Safe Harbor 401(k) Plan
This plan allows the same deferral limit as a regular 401(k) plan ($17,000 plus $5,500 catch-up), but requires slightly higher employer contributions than the SIMPLE 401(k) plan. The employer must make either a 3% contribution for all participants or a matching contribution of 100% of the first 3% of compensation deferred, plus 50% of the next 2% of compensation deferred (maximum match of 4% of compensation).
There are some differences between a 3% top heavy and a 3% safe harbor contribution which should be considered. For example, the top heavy contribution is required for non-key employees still employed at the end of the year whereas the safe harbor contribution is required for non-HCEs who were eligible at any time during the year (although HCEs are often included). Safe harbor contributions must always be fully vested but top heavy contributions can be subject to a vesting schedule.
Qualified Automatic Contribution Arrangements (QACA)
Salary deferral plans that provide a minimum matching contribution in conjunction with an automatic enrollment feature can also be exempt from the top heavy rules and ADP/ACP testing. Participants are automatically enrolled in the plan unless they elect not to participate. The default contribution rate escalates each year. Deferrals are matched at a rate of 100% of the first 1% of compensation deferred, plus 50% of the next 5% of compensation deferred (maximum match of 3.5% of compensation).
As an alternative to the matching contribution, a QACA can provide a 3% employer contribution similar to the safe harbor 401(k) requirement. Safe harbor contributions under a QACA must be 100% vested after the completion of two years of service.
Conclusion
The top heavy provisions can have surprising consequences for 401(k) plans, particularly in smaller companies, resulting in the liability for additional employer contributions. Certain strategies can help avoid such contributions and take the plan out of top heavy status.
The safe harbor alternative also requires minimum contributions but lets the plan eliminate ADP/ACP nondiscrimination testing. Accurate employee information is important for proper top heavy determinations.
This newsletter is intended to provide general information on matters of interest in the area of qualified retirement plans and is distributed with the understanding that the publisher and distributor are not rendering legal, tax or other professional advice. Readers should not act or rely on any information in this newsletter without first seeking the advice of an independent tax advisor such as an attorney or CPA.
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Spring will arrive soon, promising new growth and a fresh beginning. It could also be the perfect time to do some spring cleaning for your plan. Let’s look at some areas that you might consider reviewing to ensure your retirement plan is operating efficiently.
Document your processes and procedures to make certain that plan tasks can be handled in case of any absences during an enrollment or pay period. Having a backup in place can prevent errors and delays that could lead to penalties.
Make sure to have a process in place to notify all new enrollments of their eligibility, regardless of whether the plan has automatic enrollment. Depending on the timing for plan entry, including the plan enrollment paperwork with the new hire paperwork could make entry easier for you. Please reach out with any questions regarding when an employee enters the plan.
Deposits of employee deferrals and loan repayments must be submitted to the plan as soon as possible to avoid penalties and corrections. For plans with less than 100 participants, a safe harbor rule allows deposits to be made within seven business days. For larger plans, the expectation is that the money will be deposited more quickly. Depositing these funds on the pay date will avoid the possibility of being late.
Monitoring deferral contribution limits during the calendar year will avoid refunds after year end. Make sure that your payroll is set up to stop deferrals once the limit is reached, including any catch-up contributions for those who have reached age 50.
To keep the plan in compliance, employer contributions must be deposited timely. Due dates are impacted by the type of contributions, required status and tax deductibility. If you have questions on when to deposit your employer contribution or even whether to make an employer contribution, please contact us.
Most plans must be covered by a fidelity bond. The minimum coverage is 10% of plan assets (rounded up to the next $1,000) and the maximum coverage is $500,000. Additional requirements apply to plans with employer securities or non-publicly traded assets. If your fidelity bond is insufficient, now is the time to raise the coverage. Inflation clauses that increase the bond amount as the plan assets increase can ensure that your bond coverage is always adequate. Contact us or your insurance provider if you don’t have a fidelity bond.
Another area to review is communication with participants. Helping your employees understand and trust the plan can increase their contributions. Be sure that your procedures include distributing any plan-related communications—including required participant notices.
Distributions also involve communication, including some of the aforementioned notices. Discussing distribution options with terminated participants, possibly as part of an exit interview, can help to reduce risk of lost participants. We’ll provide instruction on distributions for force-out distributions for small balances, testing corrections and required minimum distributions.
Your plan document is the legal source on how the plan should be administered; operating within its parameters is critical. It’s always worth taking time to review the plan document to ensure that you fully understand and are following its provisions. We’ll cover more details about the plan document later in this newsletter. We’re here to support you in keeping your plan in compliance. Please feel free to reach out with any questions.
Addressing the Challenge of Uncashed Distribution Checks
Uncashed distribution checks present a persistent and often overlooked challenge for retirement plan sponsors. Despite the best efforts of plan administrators, some participants fail to cash their distribution checks, leading to administrative burdens, fiduciary concerns and potential compliance issues. A recent publication by Retirement Management Services (RMS) sheds light on this issue and offers practical guidance for employers seeking to manage and mitigate the risks associated with uncashed checks.
Uncashed checks can arise for various reasons. Participants may have moved without updating their contact information, may not recognize the check as legitimate or may simply forget to deposit it. Regardless of the cause, the responsibility for addressing these uncashed funds ultimately falls on the plan sponsor. This creates a fiduciary obligation to act in the best interest of the participant while ensuring compliance with IRS and Department of Labor (DOL) regulations.
Sponsors are encouraged to maintain up-to-date contact information for all plan participants and to follow up promptly when checks remain uncashed. This may involve sending reminder letters, making phone calls or using certified mail to confirm receipt. In some cases, plan sponsors may also consider using electronic payment methods to reduce the likelihood of checks going uncashed in the first place.
The IRS and DOL have issued guidance on how to handle these situations, including the use of forfeiture accounts and escheatment to state unclaimed property programs. However, these options come with their own set of rules and potential pitfalls. For example, using a forfeiture account may require the plan document to explicitly allow for such treatment. Escheatment laws, which allow the government to assume control of unclaimed property, vary by state. As such, plan sponsors must carefully evaluate their options and consult with legal or compliance experts as needed.
Another important consideration is the documentation of all the efforts made to contact participants and resolve uncashed checks. Maintaining a clear audit trail can help demonstrate fiduciary prudence and protect the plan sponsor in the event of an audit or legal challenge. It is extremely important to have a written policy in place that outlines the steps to be taken when a check remains uncashed beyond a certain period.
By taking a proactive, well-documented and compliant approach, employers can fulfill their fiduciary duties, reduce administrative burdens and ensure that participants receive the benefits they are entitled to.
Source: Retirement Management Services – “Uncashed Distribution Checks” https://www.consultrms.com/Resources/59/Plan-Sponsor-Tips-and-Help/212/Uncashed-Distribution-Checks
Divorce and the Retirement Plan
When a participant in a qualified retirement plan undergoes a divorce, the participant’s account balance may be an asset that is split with the former spouse. As the plan exists for the exclusive benefit of its participants, a court order is required to transfer the participant’s benefits to the ex-spouse. Once approved by the plan administrator, this court order is called a Qualified Domestic Relations Order (QDRO).
The QDRO is a judgment, decree or order that must be issued by a state authority (usually a court). It can be part of the divorce settlement or it may be a separate document. Because of the serious nature of separating the participant’s account balance, the QDRO is more than just an agreement made by both parties — it must also be signed by a judge.
A QDRO will describe how to divide the participant’s account balance between the participant and the ex-spouse, referred to as the alternate payee. In some cases, a set dollar amount will be allocated; in others, a percentage of the account may be designated. In the latter case, the amount assigned to the alternate payee represents the given percentage of the participant’s total vested account balance as of a specified valuation date. This percentage will apply to all sources — such as deferrals, matching or profit sharing — unless specified by the QDRO. Any interest and investment gains/losses that accrue between this valuation date and the date the funds are separated into an account for the alternate payee are often factored into this final calculation. If the participant has outstanding loans, the QDRO will usually indicate how the loans are handled.
Contributions such as deferrals and employer matching made after the valuation date are credited to the participant’s account. Earnings and losses are applied to the account balances. Once the division is complete, the alternate payee’s portion (either dollars or shares) is transferred to an account in the alternate payee’s name.
If the plan allows, the alternate payee may be paid out in a cash or rollover distribution. Not all plan documents allow the alternate payee to receive a distribution before reaching normal retirement age, so it’s important to follow the terms of the plan. In addition, the QDRO cannot violate the provisions of the plan document by requiring a plan to provide an alternate payee or participant with any type or form of benefit not otherwise provided under the plan.
Although the most common situation for a QDRO is a divorce, it can be issued in other situations, such as to a dependent in the case of child support. If the alternate payee is a minor child or legally incompetent, the order can also require payment to the individual with legal responsibility for the alternate payee. If a participant or their attorney provides you with a copy of a divorce decree that references the plan or a QDRO, please contact us immediately, and we will work with you to ensure it meets the requirements of the plan.
Important note for defined benefit plans: For 2025 plan years, PBGC premiums are due one month earlier than usual, specifically on the 15th day of the ninth month after the beginning of the plan year. For calendar year plans, this means the premium is due on September 15, 2025, instead of the usual October 15. This accelerated deadline is due to a provision in the Bipartisan Budget Act of 2015.
Upcoming Compliance Deadlines for Calendar-Year Plans
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