What Are Top Heavy Plans?
Top heavy plans are a classification for employer-sponsored retirement plans, primarily affecting Qualified Plans such as Defined Contribution Plans and Defined Benefit Plans. A plan is deemed "top heavy" when the total value of the accumulated benefits or account balances of "key employees" exceeds 60% of the total value of all plan assets. This classification is a critical aspect of Retirement Plan Compliance, designed to ensure that retirement plans do not disproportionately favor an organization's owners and highly compensated employees over other workers. If a plan is identified as top heavy, it must meet specific requirements, including accelerated vesting schedules and minimum contributions or benefits for non-key employees, to maintain its tax-favored status under the Internal Revenue Code.
History and Origin
The concept of top heavy plans and the associated rules were introduced as part of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). This legislation aimed to address concerns that some retirement plans primarily benefited a small group of highly compensated individuals, particularly in small businesses or professional corporations. Before TEFRA, there were different rules for corporate and self-employed (Keogh) plans, which could lead to disparities in benefit accumulation. TEFRA sought to create more parity and ensure a fairer distribution of retirement benefits across all participants in a Qualified Plan. The Act established a uniform set of rules, including the top-heavy provisions, to ensure that rank-and-file employees received at least a minimum level of benefits or contributions.19 These rules became effective for plan years beginning after December 31, 1983, and have since been a fundamental part of ERISA and IRS regulations concerning retirement plans.18
Key Takeaways
- A retirement plan is considered top heavy if more than 60% of its assets or accrued benefits belong to Key Employees.
- The primary purpose of top heavy plan rules is to prevent disproportionate benefits for owners and highly compensated individuals.
- If a plan is top heavy, specific requirements for Vesting Schedules and Minimum Contributions/benefits for non-key employees must be met.
- Failure to adhere to top heavy plan rules can jeopardize a plan's tax-qualified status.
Formula and Calculation
The determination of whether a plan is top heavy involves a calculation of the "top-heavy ratio." This ratio compares the aggregate account balances or accrued benefits of Key Employees to the total aggregate account balances or accrued benefits of all employees in the plan as of a specific determination date, typically the last day of the preceding plan year.17
The formula for the top-heavy ratio for a Defined Contribution Plan is:
If this ratio exceeds 60%, the plan is top heavy. The calculation includes distributions made to participants within the one-year period ending on the determination date.16 For plans with multiple employers or aggregated plans, the calculation can become more complex, requiring consideration of all plans within a "required aggregation group."15 The definition of Compensation used in these calculations is also specifically defined by IRS regulations.
Interpreting the Top Heavy Plan Status
A plan's top heavy status is assessed annually. If a plan is determined to be top heavy for a given plan year, it triggers certain requirements designed to ensure fairness for non-key employees. For a Defined Contribution Plan, the employer must generally provide a Minimum Contribution for non-key employees. This minimum is typically 3% of their compensation, or if the highest contribution rate for any key employee is less than 3%, then that lower percentage.14 It's important to note that elective deferrals made by non-key employees do not count toward satisfying this minimum contribution requirement.13
Additionally, top heavy plans must apply a faster Vesting Schedule for all employer contributions. This typically means either a three-year "cliff" vesting (100% vested after three years of service) or a six-year "graded" vesting schedule (gradual vesting over six years, reaching 100% after six years).12 These rules ensure that non-key employees gain a nonforfeitable right to their benefits more quickly than under standard vesting schedules.
Hypothetical Example
Consider "Tech Innovators Inc.," a small consulting firm with a 401(k) Plan. As of December 31st of the prior year (the determination date), the plan has the following balances:
- Key Employee 1 (CEO): $400,000
- Key Employee 2 (VP of Sales): $250,000
- Non-Key Employee A: $30,000
- Non-Key Employee B: $25,000
- Non-Key Employee C: $20,000
- Non-Key Employee D: $15,000
- Non-Key Employee E: $10,000
Step 1: Calculate aggregate key employee balances.
Key Employee Balances = $400,000 + $250,000 = $650,000
Step 2: Calculate aggregate all employee balances.
All Employee Balances = $650,000 (Key Employees) + $30,000 + $25,000 + $20,000 + $15,000 + $10,000 = $750,000
Step 3: Calculate the top-heavy ratio.
Top-Heavy Ratio = $650,000 / $750,000 = 0.8667 or 86.67%
Since 86.67% is greater than 60%, Tech Innovators Inc.'s 401(k) plan is a top heavy plan for the upcoming plan year. This means the company will be required to provide a Minimum Contribution to its non-key employees and ensure their accounts are subject to the accelerated top-heavy Vesting Schedule to protect their Retirement Savings. If, for example, the highest contribution rate for a key employee was 5% of compensation, Tech Innovators would generally need to contribute 3% of compensation for each eligible non-key employee.
Practical Applications
The top heavy plan rules have several practical applications in the design and administration of employer-sponsored retirement plans. Plan sponsors, particularly small businesses, must regularly monitor their plan's top-heavy status to ensure ongoing compliance with IRS regulations. This monitoring often involves sophisticated recordkeeping and analysis of participant account balances.
For plans identified as top heavy, administrators must ensure that the required minimum contributions are made to eligible non-key employees. These contributions generally cannot be satisfied by employee elective deferrals in a 401(k) Plan but must be employer contributions, such as profit-sharing contributions or employer matching contributions (though specific rules apply to how matching contributions satisfy the top-heavy minimum).11 The rules also impact the Vesting Schedule of all employer contributions for non-key employees, requiring faster vesting than might otherwise be adopted.
Understanding the top heavy rules allows employers to strategically design their plans to potentially avoid or manage top-heavy status. For instance, some companies choose to implement "safe harbor" provisions in their 401(k) Plans, which can exempt the plan from annual Non-discrimination Testing, including top-heavy testing, by committing to certain minimum contributions for all eligible employees.10 This can simplify administration and compliance significantly.9
Limitations and Criticisms
While top heavy plans rules serve the important purpose of ensuring equitable benefit distribution, they are not without limitations and criticisms. One common critique revolves around the administrative burden they can impose, especially on small businesses. Regularly determining the top-heavy ratio, identifying Key Employees, calculating required Minimum Contributions, and adjusting Vesting Schedules adds complexity to plan administration.8 Errors in compliance can lead to severe penalties, including potential disqualification of the plan, which could result in adverse tax consequences for all participants.7
Another criticism is that the rules can sometimes disincentivize small businesses from offering retirement plans altogether due to the perceived complexity and potential cost of required minimum contributions. While legislative efforts have been made to simplify retirement plan rules and provide incentives for small businesses, some argue that the top-heavy provisions still present a barrier.6 The rules are also distinct from other Non-discrimination Testing for Highly Compensated Employees, which can add layers of complexity for plan sponsors navigating multiple compliance requirements.5
Top Heavy Plans vs. Non-discrimination Testing
While both top heavy plans rules and Non-discrimination Testing aim to ensure that qualified retirement plans do not unfairly benefit highly compensated individuals, they operate differently and address distinct aspects of plan fairness.
Top heavy plans testing primarily focuses on the accumulation of benefits or assets by Key Employees relative to all other employees. If the total benefits for key employees exceed 60% of the total plan benefits, the plan is top heavy, triggering specific minimum contributions and accelerated vesting requirements for non-key employees. This test is a direct measure of whether the plan's overall asset distribution is skewed towards the ownership or management.
In contrast, Non-discrimination Testing (such as the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests for 401(k) Plans) evaluates the rate of contributions and benefits for Highly Compensated Employees compared to non-highly compensated employees. These tests ensure that the participation and contribution levels are equitable, regardless of the overall asset distribution. For example, a plan might not be top heavy if key employees have modest balances, but it could still fail an ADP test if highly compensated employees defer a significantly higher percentage of their Compensation than non-highly compensated employees. While related in their goal of promoting fairness, top-heavy rules and non-discrimination tests are separate compliance hurdles that plans must typically pass independently unless a specific exemption (like a safe harbor plan design) applies.
FAQs
What happens if a plan becomes top heavy?
If a plan becomes top heavy, the employer must generally provide a Minimum Contribution to eligible non-key employees, usually 3% of their compensation, and ensure that all employer contributions for non-key employees are subject to a faster Vesting Schedule (either three-year cliff or six-year graded).4
Are all retirement plans subject to top heavy rules?
Most Qualified Plans, including Defined Contribution Plans like 401(k) Plans and Profit-Sharing Plans, as well as Defined Benefit Plans, are subject to top heavy rules. However, certain plans, like safe harbor 401(k) plans, can be exempt if they meet specific contribution and notice requirements.3
Can elective deferrals from non-key employees count towards the minimum top heavy contribution?
No, elective deferrals made by non-key employees cannot be used to satisfy the required minimum top heavy contribution in a Defined Contribution Plan. These minimums must typically come from employer contributions.2
Is it bad if my retirement plan is top heavy?
Not necessarily. A plan being top heavy is a classification, not a failure in itself. It simply means the plan must adhere to specific rules to maintain its qualified status. The "bad" part comes if the required actions (like making minimum contributions or applying faster vesting) are not taken. Some plan designs, especially for small businesses, are intentionally structured knowing they will be top heavy.
What is a "key employee" for top heavy testing?
A Key Employee is generally defined as an officer earning above a certain indexed amount, a 5% owner of the business, or a 1% owner with compensation exceeding $150,000 (not indexed). This definition includes certain family members and can be complex.1 It is distinct from a Highly Compensated Employee.