Retirement Meditation #41: How do I fix my top heavy retirement plan?

Insights | Retirement Meditation #41: How do I fix my top heavy retirement plan?

Author: Paul A. Carl, CHSA, CPFA Vice President, Retirement Plan Consulting, Registered Representative

A law firm created a 401(k) profit sharing plan for its attorneys and staff. The firm, owned equally by four partners, included two associates, three paralegals, and a clerical/receptionist. In designing the plan to maximize contribution limits for the four partners, the third party administrator took into account that the plan would most likely become top heavy quickly. The TPA turned out to be correct in its assumptions with the firm’s 401(k) profit sharing plan becoming top heavy beginning in its second year.

For most plan sponsors, avoiding top heavy status altogether should be a priority. Sometimes, that is simply not possible. For those plan sponsors who do find the retirement plan to be top heavy (when 60% or more of the total plan benefits are attributable to IRS-defined Key Employees), the plan may become cumbersome and expensive. 

The best known “fix” for a top heavy plan is for the plan sponsor to make a top heavy minimum contribution. This is an amount that can be as much as 3% of eligible compensation for non-key employees or for both key and non-key employees; the plan document will define who receives the top heavy minimum. It’s important to note that any deferrals made by key employees to a top heavy plan will trigger the top heavy minimum contribution requirement. For example, one key employee deferring 1% of compensation into a top heavy plan will trigger a top heavy contribution of 1% from the plan sponsor.

Electing a safe harbor status for the plan may help with top heavy. The easiest to understand and implement is the 3% non-elective safe harbor contribution which meets top heavy contribution requirements. Key employees, in addition to the 3% non-elective safe harbor, may defer as much as they want (up to IRS limits) and can also receive discretionary match and discretionary non-elective contributions (subject to other compliance testing). This is not the case with all safe harbor plans, however.

The IRS also promulgates that safe harbor plans receiving only elective deferrals and safe harbor minimum contributions do not need to perform annual to heavy testing. A plan sponsor choosing the safe harbor matching contribution or the qualified auto-enrollment plan may qualify provided there is no other contribution source, including the allocation of forfeitures. The matching contributions safe harbor can be either the basic or the enhanced safe harbor match formula where 5% or 4% of deferrals, respectively, are matched up to 4% and vest immediately. The qualified auto-enrollment plan, aka QACA, matches deferrals up to 3.5% and may use the 2-year cliff vesting schedule. As a result, the QACA attracts plan sponsors with high turnover in the first year following employment.

Another remedy is available: Limit key employees from actively participating in the plan altogether. Even one deferral from one payroll by one key employee will trigger a top heavy contribution requirement by the plan sponsor. For these plan sponsors, the use of a non-qualified deferred compensation plan may become a solution.

How would you remedy your top heavy retirement plan?

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