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

• Author: McKinney, Hal H., Jr.

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...