Top Heavy Often Forgotten Rules
Rev. 03/11/10; E-mail Alert 2010-4

What are the most commonly forgotten, or perhaps overlooked, top-heavy rules? The answer may surprise you. Failure to understand top-heavy rules may be quite costly for a client, and in fact, in recent IRS examinations, failure to satisfy the top-heavy rules was one of the two most common failures. (The other was bonding which we will address in a future article.) A mastery of the rules will enable you to manage client expectations and save them from unpleasant audit experiences. This article is based on the top-heavy rules for defined contribution plans and all examples used based on the plan year being the calendar year.

The participants included in the test must have been employed during the look-back year.
If a plan participant does not have any earned income during the look back year, his or her balance is excluded from the test.

Example 1
A participant terminates employment on April 23, 2009 and on September 16, 2009 withdrew his entire balance in the plan. For the 2010 top-heavy test, the determination date balance of December 31, 2009 is used. Since the participant withdrew everything, the balance would be zero, but any amounts distributed during the one-year look-back period, (i.e. the amount distributed on September 16, 2009), are added back into the December 31, 2009 determination date balance.

In-service distributions added back for five years.
When calculating balances as of the determination date, in-service distributions that occurred in the five years before the determination date must be added back into the balance on the determination date. In-service distributions include corrective distributions such as excess contributions, excess aggregate contributions and excess annual additions, as well as plan permitted in-service and hardship withdrawals. For example, when performing the top-heavy test as of the December 31, 2009 determination date, in-service and corrective distributions for 2009, 2008, 2007, 2006 and 2005 must be added to the December 31, 2009 balance.

Example 2
Using the same facts from example 1, assume the participant took an in-service distribution of $2,500 on January 23, 2007. Although the participant had no balance on December 31, 2009, because he had income in 2009, the in-service distributions from the years 2005, 2006, 2007, 2008 and 2009 would be added to the December 31, 2009 balance. Thus, the in-service distribution of $2,500 on January 23, 2007 would be added to the December 31, 2009 balance.

Note, that for the 2011 top-heavy test, which uses the December 31, 2010 determination date balances, this participant’s 2007 in-service would be excluded because the former employee was not employed for any time during the 2010 look-back year. Therefore, the participant (and any in-service distributions the participant may have had) is dropped from the test.

If the participant is a key employee at any time during the look-back year, the person was a key employee for the entire year.


Example 3
Donald owned 51% of his company for many years. Donald sells his interest in the company but stays on as an employee working one day a week as of August 2, 2009. Donald continues to work only one day a week. When does Donald stop being a key employee for testing purposes?

As of the December 31, 2009 determination date (for the 2010 top-heavy test), Donald is still classified as a key employee because he had key employee status during part of the 2009 year. As of the December 31, 2010 determination date (for the 2011 top heavy test), Donald is no longer considered a key employee since he had no ownership during any period after 2009.

Donald continues to work in 2010 and his earned income in 2010 is classified as non-key employee income. For the December 31, 2010 determination date, Donald's balance from when he was a key employee drops out of the December 31, 2010 determination date calculation.

If the key employee account balances exceed 60%, the plan is top-heavy. There is no de minimis amount.

One of our clients had a multi-million dollar retirement plan become top-heavy by about $200. Neither the Internal Revenue Code nor the regulations provide for any leeway where the 60% is exceeded by even the smallest amount. It is a pure mathematical calculation that draws a line at the 60% amount. Thus, it is important to alert a client when the plan reaches a level approaching 60% so that the client may advise its key employees to cut back on contributions.

Example 4
On December 31, 2009, the key employees have a balance of $433,050 and the total plan balance is $720,900. This plan has 60.07% of the balance in the key employees’ accounts and thus, the plan is top-heavy. To show how little can make the difference, if the key employees' balances had been $575 less and the plan balance had remained the same, the ratio would be 59.997% and the plan would have not been top-heavy.

Last day of plan year employment rule to receive top-heavy allocation.
Only participants employed on the last day of the plan year are entitled to the top-heavy contribution in a defined contribution plan.

Example 5
Jack became eligible to participate in the plan in the year 1997. Since then Jack worked about 2040 hours in every year and received a top-heavy allocation as a non-key employee. Jack decided to terminate service as of December 23, 2009. Although Jack had worked over 2000 hours in 2009, he is not eligible for a top-heavy allocation because he is not employed on the last day of the 2009 plan year.

No 1,000 hour requirement in a defined contribution plan for a top-heavy allocation.
An eligible participant who works as little as one hour during the year and who is employed on the last day of the plan year has met the service requirement for a top-heavy allocation in a defined contribution plan. A 1,000-hour of service requirement may not be imposed even if the plan requires 1,000 hours of service for an allocation of matching or non-elective contributions.

Example 6
An eligible participant makes deferrals and only worked 800 hours during the year but was still employed on the last day of the year. In the employer’s plan, 1,000 hours of service is required to receive the matching contribution and to receive a profit sharing contribution. Thus, this participant is neither entitled to the matching contribution nor the profit sharing contribution. However, this participant is entitled to the top-heavy contribution.

Note: The defined benefit plan top-heavy rules are different and may require the completion of a year of service to be entitled to a top-heavy benefit accrual. In addition, defined benefit top heavy rules do not require the participant to be employed on the last day to accrue a top-heavy benefit.

Rule of thumb: Small plans are the most likely to become top-heavy.
It is critical to explain the top-heavy requirements when selling new prospects a retirement plan that is, or may become, subject to the top-heavy rules. The following general rules depend on several factors, among which are the number of key employees and the amounts being contributed by those key employees. In general, plans with less than 25 participants are most likely to become top-heavy; plans with 25 to 50 participants are less likely to become top-heavy; while plans with 50 to 100 participants are even less likely to become top-heavy. Plans with over 100 participants are least likely to be top-heavy, but it still can happen. Thus, a sales force should keep this rule of thumb in mind and inform the prospect of the costly consequences of becoming top-heavy as well as offering suggestions on alternate plan design options such as safe harbor 401(k) and the SIMPLE plan.

The top-heavy contribution is based on a total compensation definition.
Although overtime, bonuses, commissions and similar payments may be excluded when calculating other employer contributions; the top-heavy minimum contribution is based on total compensation for the entire plan year without any of the foregoing exclusions.

Top-heavy minimum contributions must be made for all non-key employees.
The top-heavy contribution does not have to be made to key employees. Whether the employer will want to permit its key employees to receive such contributions will depend on considerations such as costs, demographics and whether providing more allocations to key employees is making it more difficult to avoid top-heavy status. Keep in mind that to eliminate key employees from receiving the top-heavy contribution requires the selection of the appropriate plan provision.

Safe harbor 401(k) exemption from being top-heavy is a year-by-year determination.
A safe harbor plan is considered exempt from the top-heavy rules for the year in which allocations include only safe harbor contributions, elective deferrals and a discretionary match. The discretionary match must be limited to 4% of compensation and may not match on deferrals in excess of 6%. For our article on safe harbor 401(k) plans being exempt from the top-heavy contribution, click here.

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