This article originally ran on March 20, 2015.
By Ellie Lowder, TGPC, Consultant
Would you like to present an idea to the decision maker that overcomes the nondiscrimination rules that apply to employer contributions to retirement plans, and directly benefits that decision maker? Sounds like a no-brainer, doesn’t it?
It is called a top hat plan for tax-exempt 501(c) employers. That means any organization described in all 28 paragraphs of Internal Revenue Code Section 501(c), not just 501(c)(3) organizations. A top hat plan under Internal Revenue Code Section 457(b) is permitted to include only the key employees of the employers — rank-and-file employees cannot participate in the plan whatsoever.
Why? Confining eligibility only to the top rank of employees is the only way to make the plan exempt from the requirements of ERISA, which is a must! The DOL’s position is that the top employees are the decision makers in the organization, and have the ability to adopt and make decisions about their plans — and, thus, don’t need the protections of ERISA.
The ability to offer a top hat plan can solve a whole bevy of problems for tax-exempt employers, including:
- inability to benefit those key employees in the retirement plan to the extent desired (because of the application of non-discrimination rules); and
- problems passing the discrimination testing resulting too often resulting in the return of contributions to highly compensated (earning $120,000 or more in 2015) employees.
Decisions made by some of these employers include:
1. The Council on Aging, with 16 employees, has failed the nondiscrimination tests for several years, and has routinely had to return contributions to the executive director and the associate executive director. Additionally, the cost of nondiscrimination testing is an issue. Its board eliminates employer contributions to the 403(b) retirement plan for both top employees, and instead, makes employer contributions (of $18,000 per year in 2015) to a 457(b) top hat plan. No more fees for testing; the ability to benefit the two most important employees, both of which make everyone happy.
2. A small community hospital, with 300 employees, does include its key employees in the 403(b) retirement plan; however, employer contributions are very limited since the rank and file employees are not contributing at high levels. The hospital is seeking a way to offer extra benefits to its key employees, of which there are thirty. Adoption of a top hat plan solves the problem. Its board authorizes the plan by permitting each of the thirty key employees to participate with salary reduction contributions; while matching those contributions for the seven very top people. While contributions are limited to $18,000 per year (in 2015), those contributions bring the hospital more in line with the benefits packages of competitors, which helps retain those employees.
How Does the 457(b) Top Hat Plan Work?
While a 457(b) top hat plan is very similar to a 457(b) plan adopted by a governmental employer, there are a few distinct differences:
1. There is no age 50+ catch up option;
2. Rollovers are not permitted; and
3. Assets are not protected from the creditors of the employer (NOT set aside in a trust, an annuity contract or a custodial account as required for governmental 457(b) plans).
Taking the Steps to Establish the Plan
Advisors must first check with their respective product providers to ascertain their support of top hat plans. Specifically, the following steps will be need to be taken:
1. Provide a plan document that specifically addresses top hat plans to be adopted by the employer’s governing board.
2. Give the employer a sample letter directed to the Department of Labor (DOL) which the employer must file one time only to gain the ERISA exemption. That letter will notify the DOL that the employer plans to maintain the top hat plan only for a select group of key employees.
3. The employer’s selection of the group to be included. While there is no bright line standard for selection of that group, we have seen court cases which lead to the conclusion that no more than 15% of employees can be included in that group. Additionally, selection of real decision makers will be important, and those selected employees should be at earnings levels that, compared to rank and file employees, are substantially greater.
Use of the top hat plan idea will lead to direct referrals to other tax-exempt employers, and an expansion of the advisor’s practice. Study of the product provider’s materials will educate the advisors with an understanding of the requirements to promote, install, and enroll top hat plans.