Design of ‘top hat’ plans benefits high earners

Originally designed to allow a company's highest-paid executives to defer their annual cash bonus, nonqualified deferred-compensation plans have evolved into flexible, multiuse executive retirement plans — with investment options similar to their qualified-retirement-plan counterparts.

These top-hat plans are exempt from many Employee Retirement Income Security Act rules and require only a one-time filing with the Labor Department.

Section 409A of the Internal Revenue Code requires companies to decide which elements of compensation can be deferred, as well as the timing and amount of withdrawals. There is no penalty for early withdrawal as long as the plans follow 409A rules. 401(k) plans require participants to wait until they reach age 59-and-one-half to avoid paying a 10% early withdrawal penalty.

Also, unlike 401(k) plans, participants in nonqualified deferred compensation plans are not permitted to take out loans.

Neither the Labor Department nor the Internal Revenue Service has defined what constitutes a top-hat group. In Advisory Opinion 90-14A, the DOL suggested that a top-hat plan must cover only those individuals who, by virtue of position or compensation, have the ability to affect or substantially influence the design and operation of the plan.

Several courts have ruled that a plan meets top-hat criteria if participation is limited to no more than 5% of a company’s workforce. As such, most companies limit eligibility to employees holding management positions or whose salaries exceed a stated amount, typically $250,000 annually.