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Fundamentals of 457(b) Top Hat Plans

This article originally ran on May 4, 2015.

By Ellie Lowder

While the focus on adopting a top hat 457(b) plan has gradually evolved since EGTRRA (the Economic Growth and Tax Relief Reconciliation Act of 2001) removed the offset for contributions to both a retirement plan and a 457(b) deferred compensation plan, it would appear that many product providers and financial advisors have not yet embraced what might be a “sure sale.” After all, the financial advisor (with support from the provider who offers documents and technical back up) will be discussing the adoption and implementation of the top hat plan with one of the very people who will most benefit from the plan.

What Is a Top Hat Plan? 

It is a 457(b) plan sponsored by a non-governmental 501(c) employer, which must cover only a select group of key management employees. In fact, contrary to the rules for retirement plans, a top hat plan must discriminate in favor of management employees because “rank and file” employees cannot be included. This is the only way in which the Department of Labor (DOL) would be willing to potentially exempt the plan from ERISA, which is a must! 

Since the Internal Revenue Code requires that the employer own the assets in a non-governmental plan, being granted an ERISA exemption is the only way to assure that the employer’s required ownership of the assets doesn’t force an ERISA violation. By limiting the covered employees to a select group of management, the DOL takes the position that an ERISA exemption can be granted since those employees are unlikely to need the protections of ERISA since they are the decision makers with the authority to design, adopt and implement the 457(b) plan.

Where Will You Find Interest in Adopting a 457(b) Top Hat Plan? 

Any tax-exempt employer will have an interest in a plan which is designed only to reward key employees. Some of the motivating factors this writer has seen:

  • Chamber of Commerce has a 401(k) plan to which they are making matching contributions of 3% of employees’ deferrals. Their two highly compensated employees are the Executive Director and Associate Executive Director, who routinely receive a return of some of their contributions following nondiscrimination testing. The chamber would like to: 

    • avoid the cost of testing both employer contributions and elective deferrals; and
    • find a way to reward their two most important employees without running afoul of nondiscrimination rules. 

    Solution: The chamber adopts a 457(b) top hat plan, and includes both employees in that plan, while excluding them from the 401(k) plan.

    Result? Since no highly compensated employees are covered in the 401(k) plan; the plan is automatically non-discriminatory. No testing is needed.

    • The chamber makes matching contributions to the top hat plan on behalf of the two key employees of 3% of compensation ($4,500 for the Executive Director, and $3,600 for the Associate Executive Director) while the two employees contribute the balance of the $18,000 permissible limit ($13,500 by the Executive Director and $14,400 by the Associate Director). 
    • Council on Aging sponsors a 403(b) plan for its 16 employees; however, because of nondiscrimination rules, has been unable to reward their long term key management employees to the extent the council wishes to do so. The council adopts a top hat plan for the two management employees where contributions of up to $18,000 per year can be made (in 2015, as indexed) either through salary reduction contributions or employer contributions, or a combination of the two.
    What Are the Basic Rules for a 457(b) Top Hat Plan?

    • Unlike a governmental 457(b) plan, there is NO age 50+ catch up contribution, assets are not permitted to be set aside to protect them from the employer’s general creditors; and no rollovers are permitted in or out of the plan.
    • The limits, therefore, are the basic 457(b) plan limits ($18,000 in 2015) plus potential additional amounts for any under utilized limits if the final 3-year catch up is included in the plan.
    • Only key management employees can be included — no rank and file employees are permitted in the plan.
    • A plan document must be used, and a one-time filing with the DOL to gain the ERISA exemption must be made within 120 days of the adoption of the plan. A sample letter should be available for use from the product provider supporting the plan.
    Selection of the Top Hat Group
    The employer will select the top hat group based on available guidance. While the financial advisor will be guided by the product provider, certain information is available to help the employer in the selection process:

    • Court cases which lead to the conclusion that, as a rule of thumb, the number of employees included in the top hat group should be no more than 15%. 
    • Only employees who are decision makers in the organization can be included. It is not wise to expand included top hat employees to those who are supervisors (e.g., the supervisor of custodial staff would likely not be considered a key management employee).
    • The top hat group should consist of employees who earn “top” salaries, when compared to the rest of the employees, although we may not consider the top hat salaries to be “high.” In one court case of a few years ago, for example, the key employee earned $30,000 while the other employees earned $12-14,000 per year. 
    The letter which the employer will send to the DOL will supply information on how many employees it has, and, by position, which of those employees are included in the top hat group. This provides the information necessary to obtain the ERISA exemption.

    What Should Interested Financial Advisors Do?

    • Locate and contract with a product provider that supports top hat plans.
    • Carefully study their top hat materials — spend some time learning their processes and procedures.
    • If available, ask for a staff person to accompany you on your first top hat case, to quickly learn what you need to do to deliver your first plan.
    • Ask for referrals to other similar employers — you usually discover that the first case will lead to many others (especially since we are told that top hat plans have not been heavily marketed among tax-exempt employers).
    Your ability to help employers who want to benefit key employees will also lead to the strong possibility that you can also install a retirement plan for the same employer — and, it will expand your market to one that is generally not seasonal!