Top-Heavy Innoculation Exclusion

"In the event hat a Plan is top-heavy for a Plan Year, no Key Employees shall be eligbile to participate to make any Elective Deferrals under the Plan."

Is that a valid exclusion? What I'm trying to do is have a stop-gap in the plan so that even if a Key Employee contributes to a plan that ends up being top-heavy they just have ineligible contributions and not a top-heavy minimum.  We have plans where we 'know' it's going to be top-heavy eventually. We just don't know if it's in 1 year, 2 years or 3 years for example.  And of course we tell them to stop contributing in January until we can run the test but I'm afraid if someone forgets it could cost them tens of thousands.

I will tell you I asked a guru and he felt that operationally it was a cutback.  I would be comfortable explaining that risk to the client but telling them on the plus side their plan as written can never be required to fund the THM.  And that is invaluable.

The Top Heavy determination is based on account balances.  Account balances grow not only from receiving contributions but also from reallocation of forfeitures and from investment income.  Account balances for non-Key Employees shrink from decreases due to distributions, in-service withdrawals, forfeitures and also from investment losses.  High turnover among non-Key Employees and longevity among Key Employees can work together to increase the percent of total plan assets in the accounts of Key Employees.

Then there are some pesky compliance rules.  Key Employees are not necessarily Highly Compensated Employees. This can have an impact of various compliance tests depending upon the test and upon the plan's allocation formulas.

Generally, declaring a contribution ineligible after it is made to the plan is like trying to un-ring the bell.  Some have tried and failed to succeed with an argument that contributions made by Key Employees were a mistake of fact.

Now, if all of the Key Employees are in fact Highly Compensated Employees, you may get a little bit of traction with the concept by focusing on restrictions on the HCEs, but the odds of this working year-over-year are not very good.  There are unforeseen circumstances that can work against the strategy like variances in compensation due to terminations early in the year or hires late in the year, changes in ownership, changes in job responsibilities, and other similar facts and circumstances.  Never say never.

Be sure to explain everything to the client before selling them on this idea.

I mean I'll be honest, from where I sit the difference between my proposal and the exclusions sitting in al of our pre-approved documents excluding HCE's is barely noticeable.  They're out because a condition determined as of the last day of the preceding plan year was met.  That's exactly the same for both exclusions.

And your commentary about people wanting to "unring the bell" I do not think is on point.  In a top-heavy plan if the keys were eligible to contribute and they did we are on the same page, you cannot unring the bell.  I'm preventing the bell from ever being rung.

In general, I'm ok with this sort of exclusion, as long as it is carefully worded. Top heavy status is definitely determinable - it is based on the account values at the determination date. In theory one could know on January 1 whether the plan is top heavy for the year. In practice, it may take a little longer to run the test. If you have this language in the plan, and a Key employee contributes for the current year before it is known that the plan is top heavy, you have an operational failure, since the employee was not properly excluded. You could self-correct the failure by removing the contributions (with earnings) and refunding them to the employee.

Or, instead of excluding Key employees entirely when the plan is top heavy, consider keeping them eligible, but imposing a contribution limit of $0. That would let Key employees who are over age 50 make a contribution which would be immediately reclassified as catch-up, due to exceeding a plan-imposed limit. Catch-up contributions for the current year are excluded from top heavy, so this would allow them to make a contribution without triggering the top heavy minimum.

Paul's point about non-HCE Keys is a good one, and interesting. For a long time it would have been very unusual to see any non-HCE Keys, unless you had a top-paid group election and your officers and/or 1% owners were not among the highest paid employees. Now, however the HCE compensation threshold has risen higher than the compensation threshold for a 1% owner to be a Key employee* so I suspect we will start seeing this situation more and more in future years. If you had a non-HCE Key who was prevented from making deferrals due to this language, that's not necessarily a problem, but you would have to keep an eye on your coverage test and nondiscrimination tests for availability of BRFs.

* The $150,000 dollar limit was in section 416 when it was added by TEFRA in 1982 and has not been adjusted ever. One inflation calculator I found online tells me that $150,000 in September 1982 is worth over $475,000 today.

17 minutes ago, C. B. Zeller said:

Paul's point about non-HCE Keys is a good one, and interestin

Since I'm excluding ALL key employees, there would be at least one HCE that is excluded under this.  Figure that's 33% of all HCE's and I'm excluding say 1 out of 20 NHCE's.  These are made up numbers but because the vast majority of the excluded class will be HCE's coverage would be a lock.

interesting topic.....  does the employer put in any Employer contributions?  Just curious?

None.  This is intended for the small employer, where the owner makes say $80K a year wants to save what they can in 401k and provide a payroll deduction contribution opportunity for their employees. I think it's easy to forget that no one wants to be forced to right a check for tens of thousands of dollars, which is what happens to the "victims" in these scenarios.  It's hard to overstate what this means to real people who suffer the consequences of this dastardly rule.  If I can make sure that NEVER happens to them, I have done a substantial public service.

You almost got to hear my soap box speech at how cruel these rules are, particularly because of who they do target (small closely held businesses) and who they do not (Microsoft and IBM and PricewatershouseCoopers and the like).  I'll bet the director of HR at Microsoft does not even know what top-heavy is.  That's a shame.

Thanks for the context.... 

I'll just mention too that my position is the same even if they wanted to have say a 25% on the first 4% match.

3 hours ago, austin3515 said:

None.  This is intended for the small employer, where the owner makes say $80K a year wants to save what they can in 401k and provide a payroll deduction contribution opportunity for their employees. I think it's easy to forget that no one wants to be forced to right a check for tens of thousands of dollars, which is what happens to the "victims" in these scenarios.  It's hard to overstate what this means to real people who suffer the consequences of this dastardly rule.  If I can make sure that NEVER happens to them, I have done a substantial public service.

You almost got to hear my soap box speech at how cruel these rules are, particularly because of who they do target (small closely held businesses) and who they do not (Microsoft and IBM and PricewatershouseCoopers and the like).  I'll bet the director of HR at Microsoft does not even know what top-heavy is.  That's a shame.

You do know they were written because small closely held business setup plans that gave generous benefits to owners with no benefit to rank and file prior to the advent of §416.

If they don't want to make any employer contribution ever I believe they could set up salary deferral IRAs and not have to worry about the TH rules.

Quote

You do know they were written because small closely held business setup plans that gave generous benefits to owners with no benefit to rank and file prior to the advent of §416.

I do know that contributions every year are tested for nondiscrimination.  And I do know that the reason that plans become top-heavy has a lot more to do with a) how many relatives work for you; and b) how long they have been in business (owners balances go up, and employee balances stay consistent due to turnover).  And if you think there is an injustice plaguing the employees of small plans that needs to be remedied when the higher ups accumulate too much money, then those concerns could be easily addressed  in larger companies as well.  How about a rule that says if the average account of the C Suite Execs exceeds a million then that plan is top-heavy?  Just because they're bigger, is your concern about this unfairness alleviated? 

41 minutes ago, Lou S. said:

If they don't want to make any employer contribution ever I believe they could set up salary deferral IRAs and not have to worry about the TH rules.

And that's precisely what some have to do in response to these insane rules.  Tell me how that serves the American People, a worse plan with lower limits and no match of any kind.  All to avoid the top-heavy nonsense.

Austin Powers For President - 2024.  Yeah Baby!!

And the non-discrimination rules like the top heavy rules came about due to abuses in the retirement system. Maybe you're too young to recall "excess only plans". They were a little before my time but my boss used to talk fondly of them as a small plan actuary.

OK I must be the only person in the industry who thinks these rules are unfair (except I'm not).  One thing I can promise you is my client who just found out they have to drop $60,000 for a THM is not a big fan (takeover plan for us).  I'll speak on their behalf 👍.  

Oh a lot of people think the rules are unfair and an over reaction by congress back in the early 80s but there are multiple plan designs that that don't have a TH surprise taht have been expanded over the years but most require some level of ER commitment.

Salary deduction IRA

Simple IRA

Simple 401(k) (at least I think this one does I don't work with them)

Safe Harbor 401(k)

Well those are not viable options for the clients I am talking about.  Not one of them.  So again because they are closely held and in business for a while, they are severely limited in their options (and therefore so too are their employees).

Anyway I am a big fan of the Top Heavy Innoculation clause.  Curious if any last thoughts on whether or not other people think it works.  Thanks you @C. B. Zeller!  

I think you would have an unusual situation where you have a Key employee who is not also an HCE. Since all 5% owners direct and indirect are both Key and HCE it seems like the family members will likely be all the Key employees in the Plan and HCEs. Since you can always discriminate against HCEs you can probably draft language to do what you want.

I think to have non-HCE key employee you would either need an officer earning over $220K but is not an HCE because of application of TPG group or because look backs on Key/HCE compensation might be different or a 1% owner who is somehow a Key but not an HCE for similar reasons. Again both could happen but are unlikely in a small closely held corporation.

So you could set the limit on employees who are both Key Employees and HCEs equal to zero until the prior year TH test is complete. In the event that the Plan is TH you would keep the $0 dollar limit and in years you are not TH you amend out the restriction and let KEYs defer.

I sounds like the kind of provision a small closely held employer and their payroll is likely to mess up but it seems like in theory it would do what you want.

You could extend it to $0 for all Key employees and then test to see if you pass coverage on the off chance that you do have non HCE Key employees.

Essentially you are trying to exclude all the key employees from any allocation including 401(k) in any year the plan is top heavy which comes down to plan language (which might require custom document because I'm not sure your exclusion fits in a pre-approved document but may you could make an argument for putting it in some "Other field"), coordinating the deferral stop on the first few payrolls of each year until you can run the TH tests, communicating to employees (probably just the family members) why they can't make deferrals, getting new elections when you then allow them again unless your have some special language in the election form, then getting payroll to properly stop/start deferrals if/when they are/aren't suppose to happen.

Also if the Plan allows catchups, make sure you're following the universal availability rules.

So in theory yes your approach might work, in practice it seems like a VCP submission waiting to happen.

7 minutes ago, Lou S. said:

You could extend it to $0 for all Key employees and then test to see if you pass coverage on the off chance that you do have non HCE Key employees.

The nature of these plans is such that we are excluding either 100% of the HCE's or something similar, and maybe there will be one Key NHCE.  So sure passing coverage is never a given but this should be as close as you can get to deemed passing. Now, hopefully anyone who is designing plans will be paying attention to whether or not the design will pass coverage. 

1 hour ago, austin3515 said:

OK I must be the only person in the industry who thinks these rules are unfair (except I'm not).  One thing I can promise you is my client who just found out they have to drop $60,000 for a THM is not a big fan (takeover plan for us).  I'll speak on their behalf 👍.  

This is not an argument against you Austin...... just still trying to wrap my head around the plan.   You have 2 milliion in compensation for Non-Keys and let's guess 3 Keys....(or let's say it's 8 Keys, don't matter)   You are rightfully concerned the plan will go TH in 3 years or quicker.....  it appears the Keys are deferring to pass ADP and the Non-Keys are lackluster causing concern.  IMO the employer needs to bake in 3 to 4% from somewhere and go safe harbor.  Based on the scenario, the business is making money.  Unlock the deferral limits with safe harbor and make this more normal than abnormal.  You're working too hard for a plan that wants to limit the Key deferrals.  And why bother having a plan if non-Keys are sucking the life out of the plan and the Employer is not willing to go safe harbor?  And then the Keys can't defer 3 out of 5 years..... no thanks. 

Or I'm missing something of big importance....

Here is an analysis of Top Heavy plans done by the GAO in 2000 that provides explores the pros, cons, and practical considerations surrounding top heavy rules.  On balance, the rules are accomplishing the goal of having owners who derive substantial tax benefits from their company needing to provide a level of access to retirement income on behalf of the company's employees.

The trend in recent legislation has been to provide more lower cost avenues for owners to do so.

From a technical standpoint, the Top-Heavy Innoculation Exclusion sounds plausible.  From practical standpoint, it is a disaster that is waiting to happen.  The greatest risk is operational compliance, particularly when the people performing HR, payroll and benefits functions at the company are making daily decisions about who is in or out of the plan.  The Exclusion does not have a plausible corrective action in the event of an operational failure other than to make the top heavy contribution.

IMHO, we can play knight-errant and tilt at windmills, but it is our clients that suffer the consequences when facts and circumstances result in this approach fails to live up to its guarantee.

“Top-Heavy” Rules for Owner Dominated Plans.pdf

I agree that TH status is definitely determinable at the beginning of the year. 

Is Key status though?

Officers with compensation, people who become owners mid-year etc, at the beginning of the year they are part of an eligible class, and part way through the year they are not. I suppose its no different from any other participant who moves from an included class to an excluded class during a year, so hopefully the plan document addresses it. 

14 hours ago, Mr Bagwell said:

Based on the scenario, the business is making money.  Unlock the deferral limits with safe harbor and make this more normal than abnormal. 

Our opinions of what makes sense for how clients should spend their money often coincides but not always.  I doubt it will come as a surprise to you that we ran all sorts of projections, SHMAC, SHNEC excluding  HCE's.  It just didn't fly.  SHMAC without HCE's was barely $25K.  Let's face it as a small business owner, a $25K expense is a Big Frigging Deal.  Nope, they didn't want to do it. 

And absent the top-heavy rules, that would be a perfectly fine plan design and  in fact Congress had no problem with a 401k only plan design for them for the first 6 years of the Plan. The only thing that's changed is some turnover among the staff but NOT the owners.  Again the injustice is that if you happen to have 300 employees and 3 keys a plan can have this plan design no problem.  The sole difference is one is big and one is small.  If you can find me another difference between the two I'm all ears.

14 hours ago, Paul I said:

From practical standpoint, it is a disaster that is waiting to happen.  The greatest risk is operational compliance, particularly when the people performing HR, payroll and benefits functions at the company are making daily decisions about who is in or out of the plan.  The Exclusion does not have a plausible corrective action in the event of an operational failure other than to make the top heavy contribution.

This is all not correct in my opinion.  In a plan that requires this language we would monitor in the same way we monitor that plan already.  Calendar reminders, etc.  Annual mentions on phone calls.  This can be done and we are already doing it for plans on the brink of top-heavy (say 50%+).  Implementing this provision is no different than what HR already has to do to prevent the top-heavy minimum in the first place, and believe me we are making a big deal about this on those plans (as everyone should) because we know the radioactivity is off the charts.  In anticipation of your next question, the need for the exclusion is because despite our best efforts it is still humans who are in charge of execution and sometimes humans make mistakes.  Not to mention if their kid/spouse works over the summer and sees fit to do 401k.  So in case you thought the purpose of this Innoculation was to avoid of sound administration, I would like to correct the record.

And as far as operational failures go I do not need to tell you I'm sure that EPCRS has guidelines for correcting contributions to ineligible to participants.  You're suggesting the only correction for non-compliance is to do the top-heavy minimum and that is not the case.  EPCRS tells me how to correct.

And as a reminder, it is Austin Powers International Man of Mystery.  Not Don Quixote 🤣

Returning to your original question,

On 3/27/2024 at 6:12 PM, austin3515 said:

"In the event hat a Plan is top-heavy for a Plan Year, no Key Employees shall be eligbile to participate to make any Elective Deferrals under the Plan."

Is that a valid exclusion?

the answer is yes, and in fact excluding Key Employees from eligibility is explicitly available in some pre-approved plan documents.  Since pre-approved plan documents are reviewed by the IRS, that further reinforces that this is a valid exclusion.  As with all similar class exclusions (and particularly in very small plans), monitoring coverage will be critical.

The assertion:

23 hours ago, austin3515 said:

If I can make sure that NEVER happens to them, I have done a substantial public service.

implies that making the exclusion means the plan will never have to make a top heavy contribution is a stretch.  If a client is told they will never have to make a top heavy contribution by making this exclusion and in operation they do have to make one, the client certainly will plead they relied on that assertion.

How could a plan that is top heavy and that excludes key employees from making contributions ever be required to make a top heavy contribution is a valid question.  This specific situation is not addressed in EPCRS, and generally we look for analogous situations to get some guidance. 

If making a salary deferral for a key employee that was excluded from making deferrals is treated as an excess deferral, then the excess would be paid out.  If the employee is also an HCE, the excess would be included in ADP testing and it is possible the IRS would say would also be included in determining the amount of a top heavy contribution.  In an ASPPA Q&A session, the IRS confirmed that amounts refunded to a key employee are included in determining the key employee's allocation rate for top heavy purposes.

If the key employees deferral can be considered an excess allocation, then as @C. B. Zeller commented it could be returned to the employee with earnings.  There does not appear to be any guidance on whether the amount would or would not be used in determining the key employee's allocation rate for top heavy purposes.

Given the consequences, it would be prudent to get guidance from the IRS or legal counsel before telling a client they will never have to make a top heavy contribution.

Regarding the dastardly rules,

On 3/28/2024 at 10:48 AM, austin3515 said:

This is intended for the small employer, where the owner makes say $80K a year wants to save what they can in 401k and provide a payroll deduction contribution opportunity for their employees.

Assuming the plan excludes key employees, the owner of the small business who makes say $80K a year likely will have more than 5% ownership, will be excluded as a key employee and will not be able to save anything for retirement.  They will not be any better off than they would be without the exclusion.  They will just have to be satisfied that they can own up to 60% of the total plan assets in the plan.  Cue the violins.

About those windmills,

3 hours ago, austin3515 said:

And as a reminder, it is Austin Powers International Man of Mystery.  Not Don Quixote 🤣

Best of luck in getting confirmation that this strategy is a bulletproof strategy that eviscerates the top heavy rules.

An International Man of Mystery certainly can dream the impossible dream, and may your dream come true.

6 minutes ago, Paul I said:

Assuming the plan excludes key employees, the owner of the small business who makes say $80K a year likely will have more than 5% ownership, will be excluded as a key employee and will not be able to save anything for retirement.  They will not be any better off than they would be without the exclusion.  They will just have to be satisfied that they can own up to 60% of the total plan assets in the plan.  Cue the violins.

60% of $50,000 is $30,000.  Not every plan has $100MM.

Personally I don't see how this could possibly be considered an Excess Deferral.  The contributions never should have happened in the first place because they were not eligible. EPCRS says the plan should be put in the position they would have been in had the failure never occurred.

I find it extremely hard to believe that when a plan that uses the Key Employee exclusion as you describe in a pre-approved plan, and then has a failure where a key contributes through some oversight (like a new hired family member contributing), that the response is to give the top-heavy minimum.  I would implore anyone who has a preapproved document that excludes keys to pose this precise question to their document provider.  If the response is "the top-heavy minimum is due" then there is essentially no point to that checkbox.  That checkbox is just a nondynamic way of doing the same thing I am proposing, inoculating against top-heavy.  I'd say the plan is worse off having made the election, because not only do you have to do the top-heavy minimum but you also have to refund all the contributions.  What would be the point?  You could have just told the keys not to contribute (again you're talking about just the sole owner typically).

I had a client a few years ago with 300 employees where the employer gave 1/3 of them a 1.5% match.  I discovered in an annual client meeting that they were providing the wrong compensation for a >1% owner which then put his plan comp over $150,000.   He was a long-time employee who had a large balance.   I had a dreadful summer contacting different industry people, an ERISA attorney, etc.  It was not our fault, but you always have to ask - how can they pin this on us, did we not ask enough questions, etc.  It was a $150,000 issue.  The company fortunately is very successful where owners make a couple million and so they took it rather matter-of-factly and actually thanked me for keeping the plan clean.  But I was concerned about not just that plan year but the 2 following that had already passed!  Then we are talking $500,000 with earnings.  Fortunately, fixing the one year by adding $150,000 to the non-key group moved the plan into non-top heavy status for the following two.  Lucked out.  It all turned out fine but I can tell you, it affected my summer and not in a good way.  I REALLY wish the top-heavy rule would be repealed.  It is the worst thing about retirement plans in my opinion.  I'm going to consider the "innoculation" above for several clients.  Fortunately, the vast majority of our plans are small, professional and safe harbor nonelective.

@Tom thank you!

Here’s an anecdotal observation about an effect of tax law’s top-heavy condition:

Some plan creations might be lost because a business owner is unwilling to obligate her business to a safe-harbor design, and lacks tax-law advice from a smart person like those in this discussion.

I remember a service provider that rejected prospective customers a salesperson had sold because the provider feared that a plan—if not reformed into a safe-harbor design—could become top-heavy, and that the customer would blame the service provider. (“Why didn’t anybody tell me . . . !!”) The business executives decided that no set of explanations and warnings—no matter how clearly, conspicuously, loudly, and onerously stated—would deter frustrated customers from blaming the service provider. The service provider operationalized this fear by setting a minimum number of eligible employees, below which any but a safe-harbor plan was rejected.

Even with a skilled and motivated sales force, most of the rejected prospects were unwilling to adopt a safe-harbor design. Many refused even to consider it.

I describe one illustration, but my experiences with many recordkeepers and third-party administrators reveals the business problem as common.

For many reasons (including some the GAO report mentions), it’s impossible to know how many plan creations are lost because of the top-heavy condition. But is the number something more than zero?

I don’t here mention my views about minimum-participation, coverage, nondiscrimination, and top-heavy positive laws or tax-law conditions. And I don’t mention my views about designing taxes or tax expenditures.

46 minutes ago, Peter Gulia said:

Some plan creations might be lost because a business owner is unwilling to obligate her business to a safe-harbor design, and lacks tax-law advice from a smart person like those in this discussion.

Definitely add plan terminations to this list.