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The cost of success: the top-heavy Sec. 401(k) plan.

To remain qualified, under the Code, Sec. 401(k) plans must pass seven annual tests. Three of these, nondiscrimination under Sec. 401(a)(4), minimum participation under Sec. 401(a)(26) and minimum coverage under Sec. 410(b), are commonly considered matters of plan language drafting. Two others, the elective deferral limitation of Sec. 402(g)(3)(a) and the annual addition limitation of Sec. 415(c), are straightforward, by-the-numbers calculations that seldom cause problems if watched. The final two, involving actual deferral percentages (ADP) under Sec. 401(k)(3) and actual contribution percentages (ACP) under Sec. 401(m)(2), are complex and troublesome for many Sec. 401 (k) plans.

The consequences of being top-heavy

When a Sec. 401(k) plan is top-heavy, under Sec. 416, the ACP test can become tougher to meet. in addition, the plan must meet accelerated vesting requirements and provide minimum benefits to all employees.

Timing of the top-heavy test

The seven annual tests must be met at the end of each plan year-end. A plan calculates its top-heavy test at the end of its first plan year, and the end of each plan year thereafter. If it "fails" (and is top-heavy), it must make adjustments in the upcoming plan year, and for each plan year following a year-end top-heavy determination.

Overview of top-heavy test

A Sec. 401(k) plan is top-heavy if over 60% of the account balances in the plan belong to key employees.

Two terms that come up frequently in this area are "key employee" and "highly compensated employee." Top-heavy problems are stated in "key" and "nonkey" employee terms; ADP/ACP tests are done in "highly compensated" and "nonhighly compensated" terms. The two are a lot alike, but there are some subtle differences, as shown in the table on page 501.

Calculating the top-heavy test

First, take the year-end ("determination date") account balances of all employees. Add back all distributions for the prior five years to all employees (and see if any new names have to be added to the list). Subtract all rollover contributions, account balances belonging to former but no longer key employees, and accounts of former employees who have been gone for a full five years. This gives the denominator of the fraction.

Next, identify the key employees. Be sure not to count the excludible officers who do not meet any other key employee criteria.

Finally, divide the total of the key employee account balances by the derived denominator. if the answer exceeds 60%, the Sec. 401(k) plan is top-heavy for the upcoming year.

In this connection, read the plan aggregation rules of Sec. 414(b), (c) and (m) and Sec. 416(g)(2), and expand the calculation to include the other plans, if needed.

What the top-heavy plan must do

If the plan has the "kick-in" provisions of Sec. 401(a)(10)(b)(ii), the process is fairly automatic. If, on the other hand, it received its determination letter without these provisions, the plan needs to provide two major enhancements. First, it must provide either three-year so-called "cliff vesting," or a two- to six-year staged vesting formula that is faster than the three- to seven-year schedule of Sec. 411.

Next, the top-heavy Sec. 401(k) plan must provide minimum benefits for all employees, key and nonkey. Here, the highly compensated (HCE) and nonhighly compensated employee (NHCE) definitions can also become important.

Most Sec. 401(k) plans provide at least four ways for contributions to get into an employee's account. 1. Elective cash or deferred (CODA) contributions, elected by the employees from pretax compensation, then deemed employer contributions. 2. After-tax voluntary contributions, always considered employee contributions. 3. Employer matching contributions, which can match elective and/or after-tax voluntary contributions, depending on the plan language. 4. Employer nonelective contributions (NEC), so-called because the employee cannot elect to receive them in cash. These are sometimes called profit-sharing contributions. If they qualify by designation for the minimum benefits required under Sec. 416(c)(2), they are called qualified nonelective contributions (QNECs).

The minimum benefits rule

Sec. 416(c)(2) requires that every employee receive an employer contribution of 3% of compensation (again, gross compensation). This can be scaled back to the percentage in effect for the highest-paid key employee for the year.

In performing this 3% test calculation, elective deferrals of key employees count as employer contributions, but elective deferrals of nonkey employees do not.

Employer options

The employer can, in theory, characterize its minimum benefits funding as either a matching contribution (if a nonkey employee has made any elective contributions to match), or failing that, make a QNEC.

To the extent the employer designates a matching contribution for the nonkey employees to solve a top-heavy minimum benefit problem, the matching contribution does not qualify as such for purposes of the plan's ACP calculations. For a plan that is close to being top-heavy, particularly with the "2 percentage points" language of Sec. 401(m)(2)(a)(ii), this can be a real issue.

To the extent the employer has to "bargain" with certain nonkey employees to grant them additional compensation to fund elective contributions that can be matched, the employer is taking a real risk of later recanting the decision, and buying into a recurring annual morale problem with the nonkey employees who are already electing to defer voluntarily.

For these and various other reasons, most employers elect to make a QNEC, called either a top-heavy minimum contribution or simply a profit-sharing contribution, to fund the minimum benefit requirement. The employer selecting the QNEC option gets to count its contribution for both minimum benefits purposes under Sec. 416 and ACP purposes under Sec. 401(m)(2). Because of coverage requirements, this is the simpler (if somewhat costlier) option. NHCEs then have these funds available for hardship withdrawals.

One more issue

In the rare case in which a Sec. 401(k) plan coexists with a defined benefit plan, Sec. 416(h) has some additional limitations which should be reviewed.


As with most ERISA-related matters, the rules in this area are highly complex. Calculations need to be performed with painstaking care, and double-checked to identify and solve the problems of the top-heavy Sec. 401(k) plan at minimal employer cost.

Comparing Key Employees With Highly Compensated Employees
 Key employee Highly compensated employee
 (Sec. 416(i)(1)) (Sec. 414(q))
 During the plan year, During the plan year, or
 or the previous four years: the preceding one year:
1 An officer(*) with Same

compensation(**) over

2. One of the 10 employees who One of up to 20% of total
 are the largest employee employees who are the top
 shareholders(***) with paid, with compensation
 compensation over $30,000 over $50,000
3. A 5% owner Same
4. A 1% owner with An employee with
 compensation compensation
 over $150,000 over $75,000

(*) For employers with 500 or more employees, a maximum of 50 employees can count as officers for either definition; for employers with between 31 and 499 employees, there is a maximum of 10% of the employees; for those with 30 or fewer employees, there is a maximum of three who must be counted. Absent officers, the highest-paid employee for the determination year will be counted as one. Officers exclude employees with less than six months' service, those who work less than 17 1/2 hours per week or six months per year, employees under age 21 and, generally, union members. (**) Compensation is gross compensation, before reduction for contributions to cafeteria plans, self-employed plans (SEPs), the Sec. 401(k) plan itself, etc. (***) The limited attribution rules of Sec. 318 apply when measuring employee ownership, except that stock is attributed from 5%-owned instead of 50%-owned corporations. Regs. Sec. 1.401-10(d) tells how to determine who owns what percentage of the capital or profits of a partnership. Note: Dollar amounts in chart are indexed.
COPYRIGHT 1993 American Institute of CPA's
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Article Details
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Author:McKinney, Hal H., Jr.
Publication:The Tax Adviser
Date:Aug 1, 1993
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