Clarifying 401(k) Plan Rules

What Happens When Rules Are Abused?

I just got back from a trip to the West Coast.  The purpose of the trip was to meet with client groups and to tell them about the retirement services we provide.  It was not a big surprise to find out that they are very confused about 401(k) plans.  They don’t understand why the plans have so many rules; why they have to be so complicated.  I was relating this experience to a colleague, and her perspective struck me as being succinct: The rules are there because somebody abused the rules that were there before.  That abuse caused Congress to enact laws to curb it, sometimes to the detriment of the plans as a whole.

Take the Top Heavy Tests.  Please. 

This is a test that compares the total account balances of key employees to the total of all account balances.  If the key employees have more than 60 percent of the total, then the Employer is required to make a contribution to the non-keys, usually 3 percent of compensation.  This law was written back in 1982, when defined benefit pension plans were the standard retirement plan, and Employers mostly paid for retirement benefits.  The thinking of Congress at that time was: if you’re going to get a tax break for making contributions to a retirement plan, you have to make sure that the rank-and-file employees get a benefit, too.  Conceptually, that makes some sense.

The Tax Reform Act

Then came 1986, and the Tax Reform Act (TRA--it started out as the Tax Simplification Act; it didn’t end up that way).  The 401(k) plans were just starting to come into their own at that time.  The TRA added tests to make sure that the contributions going into a 401(k) plan didn’t favor Highly Compensated Employees (HCEs).  We now know those tests as the ADP and ACP tests. The rationale behind these tests was that Congress thought plans were being set up to let the HCEs defer taxes on large chunks of money and to receive matching contributions on those deferrals, without the average employee being given substantially the same opportunity to make salary deferrals and to receive matching contributions on those deferrals.  (I should mention that, at this time, 401(k) plans were thought of as supplements to the defined benefit pension plans.)  So now there were tests that had to be done, making sure that the percentage of pay deferred and matching contributions received by the HCEs was not too much greater than the percentage of pay deferred and matching contributions received by the non-HCEs.

But the Top Heavy test was still required, too.  So a situation was created where, not only must contributions be tested for discrimination on the way in, but also the balances had to be tested for discrimination each year.  In an instance where a plan sponsor has high turnover, the contributions going in each year may be just fine, but the plan becomes Top Heavy because the key employees stick around while the non-keys don’t.  As you might imagine, this can be hard for an Employer to swallow: that his individual yearly contributions are fine, but the cumulative effect is not.

So, If I Were King, What Would I Recommend?

I’m glad you asked me that! I would eliminate the Top Heavy test for 401(k) plans.  It’s anachronistic, and an employer is less likely to provide a retirement savings vehicle for his employees because of the potential impact of a test failure.  In this day of poor savings rates, we don’t need a disincentive for employers to set up a 401(k) plan.  We have the ADP and ACP tests for 401(k) plans.  We don’t need a Top Heavy test on top of those tests.

Additional Online Resources and Information:

IRS Publication: Employee Benefit Plans, Explanation No. 7, Top-Heavy Requirements

United States Department of the Treasury Fact Sheets: History of the U.S. Tax System

Some people are confused about 401(k) plans; why they have so many rules or why they are so complicated.