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Small Plans—Let’s Fix the Rules


Small employers would be more likely to offer a retirement plan if they were not required to make contributions when times are tough. This is understandable as many small companies have uncertain cash flows and a required contribution to a retirement program could jeopardize a company’s survival. Unfortunately, ERISA requires that small companies do just that.

The rules for employer sponsored defined contribution plans may look the same for large and small companies but in practice the results are very different. Large companies can exclude from their plans up to 30 percent of their workforce and limit company contributions to those who make voluntary contributions or even make no company contribution at all. In contrast, small companies must contribute 3 percent of pay for every full-time employee over the age of 21 with one year of service.

This outcome stems from the top-heavy rules, one of the many government-imposed limitations and rules designed to insure that company managers do not disproportionately benefit from 401(k) plan participation. Specifically, the top-heavy rules provide that if 60 percent of a plan’s assets are in the accounts of highly-compensated or key-employee participants, then the company must make a 3 percent contribution to all eligible employees. In addition, the top-heavy rules are among the most complex regulations in ERISA. For example, the top-heavy test is more complex than the 401(k) anti-discrimination test. Also, the definition of these considered to be in the top paid group are broader and include more employees making the test more onerous.

In practice nearly all companies with less than 50 employees will eventually fail the top-heavy test, even if they are not top-heavy initially. For companies with less than 25 employees, it is a virtual certainty. This is because small companies are owner-managed so there is virtually no turnover in the company’s highly compensated or key employees. In contrast, turnover within the rest of a small company’s workforce is usually very high -- typically higher than turnover among similar employees at large companies. Large companies where the ratio of HCEs to NHCEs is large are in no danger of failing the top heavy test and can thus take advantage of all of the plan design flexibilities provided in the rules governing qualified retirement plans.

The chart below (based upon a company with 20 NHCEs and 4 HCEs) demonstrates how small plans can become top-heavy over a four-year period. The chart assumes that four non-highly compensated employees quit and are replaced annually and that there is a one-year eligibility period. The turnover and eligibility assumptions are important because it is turnover among non-highly compensated employees that is a major cause of top-heavy test failure.

Top Heavy Test Progression

First Year
Second Year
Third Year
Fourth Year
Total Plan
Top Heavy  percent
46.90 percent
49.48 percent
56.44 percent
61.08 percent

One company with 22 employees installed a 401(k) plan that matched 50 percent on the first 15 percent of pay, a generous program by any measure. Unfortunately, the plan sponsor discovered the top-heavy test only after it had been failed. The company had to pay $17,000 in legal fees to deal with the IRS in addition to a $28,000 corrective contribution to the plan on behalf of non-key employees. Fortunately they could afford to do so.

The good news: hundreds of thousands of small employers across the United States have installed 401(k) plans. However, there will always be small employers without plans until the top heavy rules are repealed. We want as many American workers as possible to have access to a retirement plan at work. It’s time to dump the top heavy rules.

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