WHAT’S A TOP HAT PLAN?

By Ian Berger, JD
IRA Analyst
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Think of a top hat, and you’ll likely conjure up images of Franklin Delano Roosevelt or the temporarily-deceased Mr. Peanut or Rich Uncle Moneybags from Monopoly. But a “top hat plan” is also the informal name of a type of section 457(b) plan for management employees (hence the name “top hat”) of private tax-exempt companies such as hospitals. A top hat plan is different from the more common type of 457(b) plan for state and local government workers.

Who’s covered?  Because of the risks of participating in a top hat plan, those plans can’t cover rank-and-file employees. Instead, they must be limited to a small percentage of the employee population who are key management or are highly paid. In a hospital setting, this may include doctors or high-level executives.

Contribution limits. Participants in a 457(b) top hat plan can defer up to the annual deferral limit (for 2020, $19,500). Normal catch-up contributions for participants age 50 or older are not allowed. But top hat plans can allow special catch-up contributions (potentially up to another $19,500) for each of the last three years before a participant’s retirement age.

Top hat plan participants who are also in a 403(b) or 401(k) plan have a huge advantage. In that case, the contribution limits are not aggregated. So, a participant in both plans can defer up to a total $39,000 in 2020 – and even more if older.

Must be unfunded. Top hat plan funds can’t be held in trust or otherwise funded. Instead, they must remain the property of the employer and must be available to the employer’s creditors at all times. This makes them riskier than other retirement savings plans. “Rabbi trusts” (first used by a rabbi and his congregation) are often used with top hat plans. With a rabbi trust, top hat plan funds remain subject to the employer’s creditors, but the employee is protected if the employer changes the terms of the plan or if another entity becomes the employer as a result of a corporate transaction.

What’s not allowed? Certain common features of other retirement savings plans aren’t permitted in top hat plans.  For example, they can’t allow loans (although hardship withdrawals are allowed). In addition, Roth contributions may not be made. Finally, top hat plan accounts can’t be rolled over to IRAs or other plans, but may be transferred to another employer’s top hat plan. Top hat plan accounts are subject to RMDs.

Ineligible plans. 457(b) top hats are sometimes referred to as “eligible” plans. Tax-exempt employers can also establish “ineligible” plans under section 457(f) of the tax code. Employees in those plans can contribute even more than the IRS maximum. But tax on the contributions (and associated earnings) is deferred only as long as there is a substantial risk that the contributions and earnings will be forfeited. So, to avoid tax there must be a real possibility that the employee will lose his contributions and earnings.