401(k) Safe Harbor and Top-Heavy Post EGTRRA
Rev. 10/01/02

Small plans that are top-heavy may find a “401(k) safe harbor plan design” advantageous. While the 3% non-elective safe harbor contribution has been able to satisfy the minimum top-heavy contribution all along, EGTRRA provides the option to use safe harbor matching contributions to make the plan exempt from top-heavy requirements for the year. To use this option, only employee elective deferrals and employer safe harbor matching contributions can be made to the plan for that year. One possible complication is that the IRS has not given written guidance regarding situations where the 401(k) plan has a provision to allow a profit sharing contribution. Does that preclude the plan from using the top-heavy exemption if only elective deferrals and safe harbor matching contributions are actually made that year? Based on verbal IRS guidance, it is our interpretation that where no profit sharing contributions have been made over the last few years and where no profit sharing contribution is anticipated for the current year, the plan may take advantage of the new rules and avoid top-heavy status.

An additional consideration arising from EGTRRA is that any matching contribution may be used to satisfy the top heavy contribution, as of the 2002 plan year. Although the original intent of this change may have been to help the employer, it is a double-edged sword since it punishes those who participate and rewards employees who did not make deferrals. This occurs because employees who deferred to the plan, will either stop receiving or will receive a lesser top-heavy minimum contribution because any matching contribution they receive will offset the minimum contribution. In the meantime, the eligible employees who didn’t defer will still get the 3% top heavy contribution while not helping the employer to pass either the ADP or ACP tests. It should be noted that if the plan meets the top-heavy exemption referenced in the above paragraph, then those not deferring will get no contribution at all.

EGTRRA shortened the contribution suspension period imposed on participants taking a hardship distribution. In 2002, the suspension period for making elective deferrals may be reduced from 12 to 6 months. This change applies to both regular and safe harbor 401(k) plans. However, if the plan provides for safe-harbor matching contributions, rather than the 3% non-elective contribution, then the suspension period must be shortened to six months. In most cases for ease of administration, the period should probably be shortened to six months anyway.

Other top-heavy changes included simplifications of the rules used to determine who is a key employee and to determine the make up of account balances in determining top-heavy status. For example, the key employee definition of officer has witnessed an increase in the compensation definition to greater than $130,000 and has seen the elimination of the top ten owner category. This should reduce the number of key employees and would therefore make some plans less likely to be top-heavy. Also, the lookback period for determining account balances has been shortened from 5 years to 1 year, and therefore distributions (other than in-service distributions) that were made greater than 1 year ago are ignored in determining account balances. Note that in-service distributions of any kind, including excess deferrals and contributions still count for 5 years. This will have the impact of causing some plans which were not top-heavy to become so. Because of the possible change in top-heavy status, plans should be amended for these changes before the last day of the 2002 plan year for defined contribution plans.

Finally, EGTRRA also shortened the maximum allowable vesting schedules for matching contributions. All non-safe harbor matching contributions must vest at least as rapidly as under one of the top heavy schedules. At a minimum, matching contributions must be 100% vested after 3 years (if cliff vesting is used) or 100% vested after 6 years (if a graded vesting schedule is used). Matching contributions under safe harbor plans formulas are always 100% vested. Employers have the option to limit the accelerated vesting schedule to just participants who complete 1 hour of service in 2002 or they may apply the new schedule to both active and inactive participants. Also, for ease of administration employers will also want to change the vesting schedule for all contribution types to the same schedule to simplify record keeping.