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.
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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