Top-Heavy Retirement Plan: A Weighty Subject to Tackle

By David J. Kupstas, FSA, EA, MSEA

David J. Kupstas, FSA, EA, MSEA

David J. Kupstas, FSA, EA, MSEA Chief Actuary


Some names sound insulting but aren’t.  “Cumquat” sounds like a name you might call a foolish or stupid person.  Actually, it is a type of fruit.  There is a story in my family that a female relative, when being harassed by a boy on the school playground, said to him, “You reek of pulchritude!”  The boy was probably too shocked to respond, “Wow.  I think you’re beautiful, too.” 

“Top-heavy” is a pension term like that.  Whatever it means, you probably don’t want to be it.  But it’s really not so bad.  Top-heavy simply means that “key employees” have at least 60 percent of the account balances or accrued benefits.  That’s all. 

Key Employees Determine Top-Heaviness, Not HCEs 

Someone is a key employee if he is any of the following:

  1. A more-than-5-percent owner. Certain family members of more-than-5-percent owners are deemed to be key employees, too, even if they are not owners in their own right.
  2. A more-than-1-percent owner whose compensation exceeds $150,000.
  3. An officer whose compensation exceeds $175,000 (indexed). 

As you can see, key employee has a specific definition in this context.  A key employee is not just someone you think is important to the business.  People often get confused and think it is Highly Compensated Employees that determine top-heavy status rather than key employees.  Most key employees are also HCEs, and vice versa, but it is not always the case. 

Vesting Must Be Accelerated 

When a plan is top-heavy, two things must happen.  First, a top-heavy retirement plan is subject to a minimum vesting schedule.  Whatever the plan’s vesting schedule is otherwise, as soon as a plan becomes top-heavy, vesting must be no less rapid than one of the following schedules: 

  • Three-year cliff. Under this schedule, an employee is not vested until attaining three years of service, at which time he immediately jumps “up the cliff” to 100 percent vested.
  • Six-year graded. Under this schedule, a participant vests gradually, starting at 20 percent vested after two years of service, 40 percent after three years, and so on until 100 percent vested after six years of service. 

A top-heavy plan may have a more rapid vesting schedule than one of these schedules, but not a less favorable one. 

Nowadays, being top-heavy has almost no practical effect on vesting.  Most plans are already required to have vesting schedules that comply with the top-heavy rules.  Only in a traditional defined benefit plan can you get away with a less restrictive schedule than one of the top-heavy schedules.  Even then, you can go only as high as a five-year cliff or a seven-year graded schedule.  Cash balance plans and all defined contribution plans already require vesting schedules that conform to the top-heavy rules. 

In the old days, 10-year cliff and 15-year cliff schedules were common, so the top-heavy vesting rules had more of an effect then.  The law has gradually been tightened and these long vesting schedules are no longer allowed. 

Minimum Contributions and Benefits Required 

The second ramification of being top-heavy is you have to provide minimum contributions or benefits in a plan.  A defined benefit plan has to provide a monthly benefit of at least 2 percent of pay.  That 2 percent benefit needs to be provided for only 10 top-heavy years, so 20 percent of pay is the maximum top-heavy benefit needed. 

  • An employee with 10 years of participation in a top-heavy DB plan that normally provides a 1-percent-of-pay monthly benefit per year of service would need to have his benefit increased from 10 percent to 20 percent of pay.
  • An employee with 30 years of participation in that same 1-percent-of-pay top-heavy DB plan would have a benefit of 30 percent of pay. This meets the top-heavy rules, even though the benefit accrued each year is only 1 percent and not 2 percent, because the overall benefit is greater than 20 percent.
  • An employee with 3 years of participation in a top-heavy DB plan that provides a 3-percent-of-pay benefit per year would have a benefit of 9 percent of pay. This meets the top-heavy minimum because the benefit accruing each year (3 percent of pay) exceeds the minimum of 2 percent of pay. 

A top-heavy defined contribution plan has to provide an annual contribution of 3 percent of pay to non-key employees unless no key employee receives 3 percent of pay.  In that case, the non-key employees have to get whatever percentage the key employees are getting. 

  • If no key employees receive any contributions for the year, the non-key employees also do not need to receive any contributions.
  • If 2 percent of pay is the highest contribution to a key employee, all non-key employees must receive at least 2 percent of pay.
  • If 10 percent of pay is the highest contribution to a key employee, all non-key employees must receive at least 3 percent of pay. 

401(k) Deferrals Are a Booby Trap 

Deferrals are counted in the annual contribution test for key employees but not for non-key employees.  Suppose there is a top-heavy plan where it is intended for the only contributions to be salary deferrals.  No match, profit sharing, or any other employer contributions are planned to be made.  A key employee defers 3 percent of pay.  Even though the employer did not plan on contributing a dime for the year, now it has to contribute 3 percent of pay for all non-key employees. 

What’s more, any salary deferrals made by non-key employees do not count toward satisfying their 3 percent minimum.  Even if all of the non-key employees defer a greater percentage of pay than the key employees, in this example the employer still has to kick in 3 percent of pay for all the non-key employees.  Ouch!  This is definitely something to watch out for when a company starts a 401(k) plan at the very end of the year.  If a key employee defers 3 percent of pay just before year-end and the plan is top-heavy, the employer is going to have to give a 3-percent-of-pay contribution based on a full year of compensation to all non-key employees.  That is not a pleasant thing to have to communicate. 

Other Tidbits About Top-Heavy Contributions 

  • A safe harbor 401(k) plan in which the only employer contributions are those needed to satisfy the safe harbor is exempt from top-heavy minimum allocations.
  • A participant in a defined contribution plan who is not employed on the last day of the year does not need to receive the top-heavy minimum for that year. There is no such rule in DB plans; a participant who has enough hours of service for a benefit does not need to be employed on the last day of the year to get the top-heavy minimum.
  • When an employer sponsors both a defined contribution and a defined benefit plan, a plan needs to provide the top-heavy minimum in only one plan or the other, not both. If the top-heavy minimum is to be satisfied in the DC plan, the minimum percentage of pay is 5 percent rather than 3 percent.  If the top-heavy minimum is to be satisfied in the DB plan, the minimum benefit percentage remains 2 percent.  You can also write the plans so part of the top-heavy minimum is satisfied in the DC plan and part in the DB. 

Are Top-Heavy Rules Even Needed Anymore? 

The ERISA Advisory Council and other organizations have called for a repeal of the top-heavy rules.  We wholeheartedly agree.  As mentioned above, the vesting provisions have little practical effect anymore.  They are just taking up space in the Internal Revenue Code.  As far as the minimum contributions go, top-heavy rules have in many ways been made superfluous by other rules, such as the gateway rules.  Nevertheless, valuable time must be spent each year doing calculations to determine whether a plan is top-heavy or not. 

Perhaps more importantly, the top-heavy rules unfairly punish small plans.  A plan with one owner and one employee is almost surely going to be top-heavy, whereas a plan with one owner and 20 employees likely will not be top-heavy.  The smaller company did not do anything wrong or abusive to become top-heavy.  Yet, it has to provide a top-heavy minimum merely because of its smaller size, while the larger company does not have to. 

Regardless of the complexity or unfairness of these rules, just make sure you are not insulted when someone calls your plan top-heavy.  It is nothing to be ashamed of.

— Topics: 401(k), Retirement