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Top Heavy Testing

Ascensus Consulting is an independent third-party administrator that performs required compliance testing and non-discrimination testing for tax qualified defined contribution, defined benefit, and cash balance plans to help ensure that employers are following the rules and laws set forth by the Internal Revenue Service and the Department of Labor.

The compliance tests help verify that contributions are being allocated properly and in a timely manner. The non-discrimination tests help ensure that the plan does not discriminate in favor of highly compensated employees.
 
The consequences for employers that are not in compliance, intentionally or not, are severe and could include heavy civil or criminal penalties imposed by the Internal Revenue Service or Department of Labor.

The Top Heavy Test looks at the degree to which certain officers and owners dominate the 401(k) plan. A top heavy plan is a qualified retirement plan that favors these key employees over non-key employees. There are a number of plan design strategies that can help satisfy top-heavy requirements while providing the employer with more bang for the buck, and some that exempt the plan from the top-heavy rules.

The basics

A defined contribution retirement plan is top heavy if the combined value of key employee plan accounts (whether vested or not) exceeds 60% of the total value of all plan accounts. Determining whether a defined benefit pension plan is top heavy is based on a similar formula using the present value of accrued benefits (i.e., what retirement benefits at normal retirement age are worth today).
If a defined contribution plan is top heavy, minimum contributions (generally up to 3% of a participant’s full-year compensation) must be made to all non-key employees who are employed on the last day of the plan year and who are eligible to receive an allocation from or make contributions to the plan. Defined contribution plans must always use a top-heavy (three-year cliff or six-year graded) or faster vesting schedule.
 
In a top-heavy defined benefit plan, minimum accruals are required (generally, a benefit accrual of 2% for each top heavy year of participation, up to 10 years of participation) for all non-key employees who complete 1,000 hours of service during the year (even if separated from employment). However, depending on the plan’s formula, it is possible that actual contributions will not need to be made in a given year for each non-key employee. If a defined benefit plan is not using a top-heavy vesting schedule (three-year cliff or six-year graded) and it becomes top heavy, it is required to accelerate the vesting schedule.
 
If an employer has both a defined benefit plan and a defined contribution plan, special rules apply. 

Top heavy 401(k) designs

Elective deferrals made by a key employee are considered employer contributions for top heavy purposes. If a key employee makes a deferral to a plan that is top heavy, and no other employer contributions are made, the plan must make a minimum top heavy contribution on behalf of non-key employees, even if there are no other employer contributions. (The key employee is not permitted to take back the elective deferral to avoid this situation.)

There are several options for satisfying 401(k) plan top heavy requirements. Any employer contributions (including matching, profit sharing, qualified, or safe harbor contributions) may be counted toward satisfying the 3% top heavy contribution. Note, however, that the top heavy contribution must be based on full-year compensation with no exclusions. If a plan’s profit sharing contribution formula is based on less than a participant’s full-year compensation, an additional contribution may be necessary.

A 401(k) plan that is designed as a safe harbor 401(k) plan will be exempt from the top heavy rules as long as only elective deferrals and contributions that satisfy the safe harbor are allocated in a given year. If the employer makes additional profit sharing contributions or reallocates any preexisting forfeitures, the safe harbor plan would no longer be exempt. In this situation, employer contributions may still count toward satisfying the top-heavy minimum.

Defined contribution and defined benefit designs

An employer with a top heavy defined contribution plan and a top heavy defined benefit plan may satisfy top heavy requirements by making required allocations to both plans or by:
  • Providing the minimum benefit in the defined benefit plan
  • Providing the minimum contribution to the defined contribution plan; requires a top heavy contribution of 5% instead of 3%
  • Providing the minimum top heavy defined benefit plan benefit with a floor offset, where the minimum defined benefit plan benefit is offset by the defined contribution plan benefit
  • Providing some top heavy contributions to both plans, provided the combined benefits are at least equal to the minimum top-heavy contribution for the defined benefit plan
In many cases, the most cost-efficient method is to make an accrual contribution to the defined benefit plan. Why? If the workforce is relatively young, then the current value of contributions may be less than an allocation to the defined contribution plan. In addition, accruals to a defined benefit plan are capped at 10 years, and the plan’s formula may be in excess of the 2% required. The defined benefit plan’s actuary should be consulted.

Generally, top heavy status is determined as of the last day of the immediately preceding plan year. SIMPLE 401(k) plans and SIMPLE IRAs are exempt from the top heavy rules.
 
Contact us for more information on compliance testing.