Don't Forget
Rev. 08/18/05, E-mail Alert 2005-16

Top heavy oft-forgotten rules
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, while a mastery of the rules will enable you to manage client expectations from the earliest stages of the planning process. This article is based on the top-heavy rules for defined contribution plans. All examples in this article are 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, 2008 and by September 16, 2008 withdrew his entire balance in the plan. For the 2009 top-heavy test, the determination date balance of December 31, 2008 would be used. Of course, since the participant withdrew everything, his or her balance would be zero, but any amounts distributed during the one-year lookback period, in this example the amount distributed on September 16, 2008, would be added back into the December 31, 2008 determination date balance.

In-service distributions added back for five years.
When calculating balances as of the determination date, in-service distributions that occur during 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, 2008 determination date, in service and corrective distributions for 2008, 2007, 2006, 2005 and 2004 must be added to the December 31, 2008 balance.

Example 2
Using the participant fact pattern from example 1, and adding an in-service distribution of $2,500 on January 23, 2007. Although the participant had no balance on December 31, 2008, in-service distributions from the years 2004, 2005, 2006, 2007 and 2008 would be added to the December 31, 2008 balance. Thus, the in-service distribution of $2,500 on January 23, 2007 would be added to the December 31, 2008 balance.

Note, that for the 2009 top heavy test, which uses the December 31, 2008 determination date balances, this participant’s in-service would not be added-in as the former employee was not employed for any time during the 2008 look back year and thus the participant (and any in-service 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.

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, 2008, 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 had $575 less and the plan balance had been the same, the plan would have not been top heavy with a ratio of 59.997%.

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, 2008. Although Jack had worked over 2000 hours in 2008, he is not eligible for a top-heavy allocation because he is not employed on the last day of the 2008 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 there on the last day to accrue a top-heavy benefit.

Rule of thumb: Small plans are the most likely to become top heavy.
When selling new prospects a retirement plan that is subject to the top-heavy rules, it is critical to explain the top-heavy requirements. The following generalizations are dependent 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 can still 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, severance pay, commissions and similar payments may be excluded when calculating other employer contributions; the top-heavy minimum contribution is based on total compensation without any of the foregoing exclusions.

Top-heavy minimum contributions must be made for all non-key employees.
Legally, 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 no longer be top heavy. Selecting the appropriate plan provision can eliminate the top heavy contribution to key employees.

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.

Bill Grossman, QPA