Safe Harbor 401(k) Top-Heavy Plans
Rev. 02/25/10; E-mail Alert 2010-3

Small business owners commonly select a safe harbor 401(k) retirement plan design. These same employers often see their plans become top heavy. A plan is considered top heavy when more than 60% of the aggregate value of the plan accounts belongs to key employees — the owners and officers of the business.

Coordinating Contributions
If a plan becomes top heavy and any key employee has had an allocation (including elective deferrals) of 3% or more, then the employer must provide an allocation of 3% to all eligible non-key employees. However, if it is a safe harbor 401(k) plan, the employer is already providing a contribution, so there are special top-heavy rules that apply to safe harbor plans.

If a safe harbor 401(k) plan is top-heavy, the employer can get twice the mileage out of its safe harbor contribution. There are three ways this can happen:

1. If a nonelective contribution of 3% or more is made to a top-heavy plan, that contribution will generally satisfy the top-heavy contribution requirement. However, if the safe harbor 3% nonelective is based on less than entire plan year section 415 compensation, than an additional allocation necessary to meet the entire plan year 415 compensation would be required to satisfy the top heavy allocation requirement.
• For example, if a participant entered the plan July 1 (after a one year of service requirement was met) and the plan called for a safe harbor 3% NEC — with a compensation computation period of while a participant — then the participant would only receive six months of 3% safe harbor NEC. To satisfy the top heavy allocation requirement, an additional six months of 3% top-heavy contribution would be needed.
2. If a plan that is top heavy calls for making a safe harbor matching contribution (and is not exempt as described below), then the safe harbor contribution will count towards satisfying the top-heavy minimum contribution for those employees who receive it. For example, if a participant defers 2% and receives a 2% safe harbor match, when the employer makes the top-heavy contribution, that employee would need to receive only 1% to satisfy the 3% top-heavy contribution.
3. In Rev. Ruling 2004-13 (detailed below), the IRS provided the circumstances under which a safe harbor 401(k) plan would be exempt from the top-heavy rules. Basically, to be exempt, there cannot be any employer contributions to the plan other than elective deferrals and contributions that satisfy the ADP and ACP safe harbor. Thus, there can be no profit sharing contributions. Forfeitures generally may not be allocated as additional contributions. There is an exception that permits discretionary matching contributions provided they stay within the ACP safe harbor requirements of being less than 4% of compensation and not matching deferrals that exceed 6% of compensation.

An Annual Determination
Top-heavy status is determined on a yearly basis. If a profit sharing contribution was made in 2009, for example, the plan cannot be exempt from the top-heavy rules in 2009. However, if no profit sharing contributions are made in 2010 and no employer contributions are made (other than those that meet the safe harbor), then the plan will be exempt from the top-heavy rules for 2010.

Revenue Ruling 2004-13 clarified rules for a 401(k) safe-harbor plan to be exempt from being top heavy

This guidance made it clear that the determination of whether a plan is exempt from the top-heavy rules is to be re-determined each year. In all the examples in the ruling, the safe-harbor matching contribution is used to illustrate satisfying the top-heavy exemption; note that the safe-harbor nonelective contribution may also be used.

This ruling clarified through specific scenarios when a safe-harbor plan is exempt from being top heavy and when it is not.

These situations are exempt from the top-heavy rules:

• If a safe-harbor 401(k) plan has only elective deferrals and the safe-harbor matching contribution, the plan is exempt from being top heavy.

• If a safe-harbor 401(k) plan provides for elective deferrals and the safe-harbor match contribution and it has a plan provision to permit for a discretionary nonelective contribution, but the employer does not make a discretionary nonelective contribution, the plan is exempt from being top heavy.

In the following situations, the safe-harbor 401(k) matching contribution plan will not be exempt from being top heavy:

• When the employer makes a discretionary nonelective contribution;

• When forfeitures are allocated to participants accounts in the same manner as nonelective contributions; and

• When employees are eligible to make elective deferrals upon hire but are not eligible for the match until after one year of service is completed. This is explained in detail below.

According to the ruling, a safe-harbor 401(k) plan will not be exempt from the top-heavy rules if it permits immediate or short eligibility for an employee to enter the plan for elective deferrals, but imposes a longer service requirement for the employee to enter the plan to receive safe-harbor matching contributions.

In a safe-harbor 401(k) plan that permits employees to defer before meeting the statutory one-year-of-service requirement, but that requires a longer period of service before being eligible for the safe harbor matching contribution, the plan is not eligible for the top-heavy exemption. Why? Because newly-hired nonhighly compensated employees (NHCEs) will not be eligible to receive the same level of contributions as longer-term highly compensated employees (HCEs), and thus, the plan does not satisfy the requirements for the top-heavy exemption. This has a significant impact on the plan. For example, longer-term non-key employees who are eligible to defer but did not contribute any deferrals would now be eligible to receive the top-heavy minimum. Those who deferred 1 or 2 percent might also be eligible to receive the difference up to the 3% (and they would be, if the plan's top-heavy minimum is actually 3%.) Since staggered eligibility is a normal design method, employers should consider this rule when designing their plan's eligibility.

For much more on top heavy plan rules, click here for information or to register for our Top Heavy eSeminar.