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Top Heavy Safe Harbor Plans

“One of my clients has a safe harbor 401(k) plan and his recordkeeper told him the plan was top heavy. How could that be? I thought all safe harbor plans were exempt from the top-heavy testing rules.”

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with a financial advisor from Florida is representative of a common inquiry related to safe harbor 401(k) plans.

Highlights of Discussion

No—not all safe harbor plans are exempt from the top-heavy rules.

A safe harbor plan that provides for salary deferrals and just the required safe harbor contribution (i.e., either the employer matching or nonelective contribution) would be exempt from top-heavy testing. However, there are three scenarios that would make a safe harbor plan subject to top-heavy testing, according to Revenue Ruling 2004-13:

  1. If, in addition to employee salary deferrals and the employer’s safe harbor contribution, the plan allocates an additional profit-sharing contribution;
  2. If the plan allocates forfeitures as a profit sharing contribution; and
  3. If employees are eligible to make elective deferrals upon hire but are not eligible for matching contributions until after they complete one year of service.

If your client’s safe harbor plan falls under one of the three above-listed exceptions, then the plan will have to be tested for top-heaviness. In general, a plan is considered top heavy if more than 60 percent of the plan’s assets belong to key employees. A top-heavy plan must satisfy minimum contribution and vesting requirements (see Treasury Regulation 1.416, Q&A Sections V and M).

Here are a couple of extra pointers regarding the minimum contribution requirement for safe harbor plans that fail top-heavy testing:

  • Safe harbor employer contributions can be used to help satisfy the minimum contribution requirement for a top-heavy plan.
  • When determining the top-heavy minimum contribution amount, the plan must use “full year compensation,” regardless of how the plan document defines compensation for contribution purposes (see Treasury Regulations 1.416-1, Q&As M-7 and T-21).

Conclusion

Not all 401(k) safe harbor plans are exempt from top-heavy testing. The IRS has identified three scenarios in which safe harbor plans would be required to apply the test and, if found to fail, meet minimum contribution and vesting requirements.

 

© Copyright 2022 Retirement Learning Center, all rights reserved
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Adding In-Service Distributions to a Company’s Retirement Plan

“What are the considerations around adding an in-service distribution option to a company’s qualified retirement plan?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with a financial advisor from New Jersey is representative of a common inquiry related to in-service distributions from qualified retirement plans.

Highlights of the Discussion

There are several important considerations surrounding adding an in-service distribution option to a company’s qualified retirement plan, including, but not limited to,

  • Type of plan,
  • The process to add,
  • The parameters for taking,
  • Potential taxes and penalties to recipients,
  • Nondiscrimination in availability, and
  • The effect on top-heavy determination.

Several types of retirement plans can offer in-service distributions, including 401(k), profit sharing, employee stock ownership and even defined benefit plans. If a plan sponsor desires an in-service distribution option, it must be formally written into the plan document, either when adopted or later through a plan amendment. The plan sponsor would need to check with its document provider for the exact adoption or amendment steps. For example, adding an in-service distribution option to a prototype 401(k) plan can be as easy as checking a box on the adoption agreement, selecting an effective date, signing the amendment and notifying participants of the change.

There are pros and cons to including an in-service distribution option in a plan. The pros include increased participant control of plan assets, and a higher level of participant satisfaction with the plan. The cons include the potential for greater administrative burdens and cost to the plan sponsor as a result of an increase in the number of distribution requests, potential taxes and penalties for the distribution recipient, and depletion of savings meant for retirement income.

Plan participants need to understand the taxation rules that apply to in-service distributions. Any pre-tax amounts that are distributed from a plan prior to age 59½ will be subject to taxation and, possibly, an early distribution penalty tax, unless an exception applies. Completing a rollover of the in-service distribution either directly or indirectly within 60 days of receipt is one way to delay any tax impact.

If a plan sponsor wants to add an in-service distribution option, it can choose to make the option very liberal or attach restrictions such as a requirement for a participant to reach a certain age, or complete a set amount of service. It is important to note that the IRS does not allow employee pre-tax elective deferrals to be distributed prior to age 59½, nor defined benefit assets to be distributed prior to age 62 under the in-service distribution rules. The plan sponsor could also limit access to a particular contribution source or sources (e.g., matching contributions, after-tax, etc.).

Distributions are part of the benefits, rights and features of a plan under Treasury Regulation §1.401(a)(4)-4. Therefore, if a plan offers in-service distributions, it must do so in a nondiscriminatory manner (i.e., not make them disproportionately more available to highly compensated employees (HCEs) than nonHCEs).

Finally, keep in mind that in-service distributions from a qualified retirement plan can affect top-heavy determination for up to five years. A plan is top-heavy if the key employees own more than 60 percent of the plan’s assets or benefits on the determination date. In-service distributions for active employees are added back to account balances if the distribution occurred within the five-year period ending on the determination date (Treasury Regulation §1.416-1, T-30)).

Conclusion

When the desire to give plan participants greater control of their plan assets exists, plan sponsors and participants may look to in-service distributions of retirement plan assets as a possible solution. But there are several important considerations surrounding such a plan feature. Financial advisors can help educate their clients on the pros and cons of adding, or changing the terms of an existing, in-service distribution option.

 

© Copyright 2022 Retirement Learning Center, all rights reserved
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401(k) After-Tax Contributions May Be Testy–But Worth It

“What are the limitations, if any, on making after-tax contributions to a 401(k) plan?” Read more

© Copyright 2022 Retirement Learning Center, all rights reserved