What Is a Top Hat Plan?

A top hat plan is a type of employer-sponsored plan that is unfunded. The design of the plan is to provide deferred compensation to the eligible employee group. However, participants in a top hat plan are typically high-ranking executives and directors.

How a Top Hat Plan Works

Top hat plans differ from standard employer-sponsored retirement plans like 401(k)s and 403(b)s. Unlike those plans, top-hat plans are not meant to be tax-qualified. So, they don't usually offer the same tax benefits of an opt-in employer-sponsored plan. One of the primary distinctions of a top hat plan is that, as the name implies, only certain employees can enroll in and benefit from this plan. Each company will determine membership requirements for the sponsored plan. Not everybody can participate. Even those of equal company stature may have different plans.

Top hat plans are unfunded, which means that money contributed to them is not held in trust for the employees. Instead, the assets remain the property of the employer company until the employee leaves. The employer chooses who can participate and it can decide whether and how much to contribute.  

A nonqualified deferred compensation plan allows participants to defer income into the plan during each calendar year. A supplemental executive retirement plan is funded entirely by the employer.

Advantages and Disadvantages of a Top Hat Plan

One significant advantage of a top hat plan is that it does not need to undergo non-discrimination testing by regulatory bodies. Members of the plan can contribute as much as they please, a feat not typical in traditional retirement plans that face annual limits. However, contributions to top hat plans such as non-governmental 457(b) plans are immediately taxable. All distributions from top hat plans are also subject to income tax. 

By design, top hat plans avoid a few regulatory requirements. They are typically exempt from several provisions relating to funding, vesting, and participation. The plans also avoid some accrual and fiduciary obligations.

The Employee Retirement Income Security Act (ERISA) will govern a top hat plan. Thus, it must meet some specific requirements as well as some reporting and disclosure rules. For instance, the Internal Revenue Service (IRS) requires reporting of all employee contributions and employer deferrals to top hat plans. Contributions appear on the plan sponsor's Form-W2. 

The plan may also need to contain specific features such as loans, emergency distributions, and age-based catch-contributions. Also, the plan must apply for top hat status with the Department of Labor and maintain a copy of the application.