13.2 Top-Paid 20% Group Election & Determination Year Mechanics

13.2 Top-Paid 20% Group Election & Determination Year Mechanics

[!NOTE] Strategic Demographics: Managing the HCE Population In professional service firms, technology startups, financial institutions, and medical practices, a substantial percentage of the workforce often earns compensation exceeding the statutory dollar threshold ($160,000 for 2025/2026). Under the default statutory test of IRC §414(q)(1)(B), every single employee exceeding the threshold is classified as an HCE. In an organization where 40% of the staff earns over $160,000, this default classification severely swells the HCE ranks, drags down the non-owner testing averages, and causes immediate failures in the ADP and ACP nondiscrimination tests under IRC §401(k)(3) and §401(m)(2). To mitigate this demographic trap, Congress enacted the Top-Paid Group (TPG) Election under IRC §414(q)(1)(B)(ii).

For retirement plan practitioners preparing for the ASPPA QKA examination, mastering the four-step mathematical calculation of the Top-Paid Group, navigating statutory exclusions, understanding rounding conventions, and applying the Calendar Year Data Election under IRS Notice 97-45 are essential computational skills.

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Statutory Basis and Business Purpose of the TPG Election

Under IRC §414(q)(1)(B)(ii), an employer may elect to apply the compensation test by classifying an employee as an HCE only if the employee:

1. Received statutory compensation from the employer in excess of the statutory dollar threshold ($160,000 for 2025 lookback) during the lookback year; AND
2. Was in the Top-Paid Group (TPG) of employees for the lookback year.

What is the Top-Paid Group?

The Top-Paid Group is defined by statute as the top 20 percent of employees of the employer ranked on the basis of compensation paid during the year.

The Operational Effect of Electing TPG

When an employer elects TPG, the number of employees who can become HCEs under the compensation test is strictly capped at 20% of the employer's net workforce. Any employee whose compensation exceeds $160,000 but who falls outside the top 20% ranking is reclassified as a Non-Highly Compensated Employee (NHCE)!

+---------------------------------------------------------------------------------------------------+
|                             THE TOP-PAID GROUP (TPG) RECLASSIFICATION                             |
+---------------------------------------------------------------------------------------------------+
|                                                                                                   |
|   SCENARIO: Employer with 50 Employees; 20 earn over $160,000 in Lookback Year; 0 are 5% owners.  |
|                                                                                                   |
|   [ DEFAULT STATUTORY RULE (No TPG) ]                [ TOP-PAID GROUP ELECTION (TPG) ]            |
|   • All 20 employees earning > $160k are HCEs.       • TPG Cap = 50 × 20% = 10 HCE Slots.         |
|   • HCE Count = 20 Employees (40% of staff!)         • Top 10 Earners = HCEs                      |
|   • NHCE Count = 30 Employees                        • Next 10 Earners (> $160k) = RECLASSIFIED   |
|   • High risk of failing ADP/ACP test due to           AS NHCEs!                                  |
|     large, highly paid HCE testing group!            • HCE Count = 10 Employees (20% cap)         |
|                                                      • NHCE Count = 40 Employees (Massive Boost   |
|                                                        to NHCE ADP Testing Benchmark!)            |
|                                                                                                   |
+---------------------------------------------------------------------------------------------------+

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The Four-Step TPG Calculation Methodology

Treasury Regulation §1.414(q)-1T, Q&A-9 establishes a rigorous four-step procedure that plan administrators must execute to determine the Top-Paid Group for a lookback year:

+---------------------------------------------------------------------------------------------------+
|                           THE 4-STEP TOP-PAID GROUP DETERMINATION PIPELINE                        |
+---------------------------------------------------------------------------------------------------+
|                                                                                                   |
|   [ STEP 1: ESTABLISH TOTAL WORKFORCE ]                                                           |
|   Count all individuals employed by the employer (and entire controlled group) during lookback.   |
|                                     │                                                             |
|                                     ▼                                                             |
|   [ STEP 2: SUBTRACT STATUTORY EXCLUSIONS ]                                                       |
|   Subtract employees who satisfy statutory exclusion criteria (Age, Service, Hours, Union, etc.).|
|                                     │                                                             |
|                                     ▼                                                             |
|   [ STEP 3: CALCULATE THE 20% HEADCOUNT CAP ]                                                     |
|   Multiply Net Workforce from Step 2 by 20% (0.20). Apply statutory rounding rules (≥ 0.5 up).   |
|                                     │                                                             |
|                                     ▼                                                             |
|   [ STEP 4: RANK ALL EMPLOYEES BY COMPENSATION & APPLY CAP ]                                      |
|   Rank ALL employees by compensation. The top N employees equal to the Step 3 cap who earn        |
|   more than the statutory threshold are HCEs under the compensation test.                         |
|                                                                                                   |
+---------------------------------------------------------------------------------------------------+

Step 1: Establish Total Workforce

Count every individual who was employed by the employer (including all members of a controlled group under IRC §414(b)/(c) or affiliated service group under §414(m)) at any time during the lookback year.

Step 2: Subtract Statutory Exclusions (Treas. Reg. §1.414(q)-1T, Q&A-9(b))

Under IRC §414(q)(5) and Treas. Reg. §1.414(q)-1T, Q&A-9(b), the employer subtracts specific categories of employees to arrive at the net workforce for denominator calculation purposes. An employee is excluded if, as of the end of the lookback year, they satisfy any of the following statutory criteria:

[!NOTE] Plan Document Election for Exclusions: An employer may choose to apply none of these exclusions, or may adopt lower age or shorter service requirements in its written plan document. However, an employer cannot exceed the statutory limits. For instance, a plan document cannot exclude employees with less than 1 year of service or employees under age 25 for TPG headcount calculation purposes.

Step 3: Calculate the 20% Headcount Cap & Apply Rounding Rules

Take the net workforce determined in Step 2 and multiply by 20% (0.20):

$\text{TPG Headcount Cap} = \text{Net Workforce (after Step 2 Exclusions)} \times 0.20$

The Statutory Rounding Rule: Treas. Reg. §1.414(q)-1T, Q&A-9(b)(1)

When multiplying the net workforce by 20% yields a fractional number, administrators must follow the explicit regulatory rounding convention:

• Any fraction of one-half (0.50) or greater is rounded up to the next higher whole number.
• Any fraction of less than one-half (under 0.50) is disregarded (rounded down).

Step 4: Rank All Employees by Compensation and Apply the Cap

Once the numerical cap is established in Step 3, the employer ranks employees by statutory §415 compensation earned during the lookback year.

[!IMPORTANT] The Master Ranking Rule (The Number vs. Identity Rule): This is the single most heavily tested distinction on the ASPPA QKA examination! Under Treas. Reg. §1.414(q)-1T, Q&A-9(a)(2):

• The statutory exclusions in Step 2 are used SOLELY to calculate the headcount cap (the NUMBER of employees in the TPG).
• In Step 4, when determining WHICH PARTICULAR EMPLOYEES fill those capped slots, ALL EMPLOYEES WHO PERFORMED SERVICES ARE RANKED BY COMPENSATION, including employees who were excluded in Step 2!

Example: An employee is 19 years old (excluded under Step 2 for denominator purposes) but earned $220,000 during the lookback year. That employee is NOT excluded from the ranking in Step 4! They are ranked according to their $220,000 compensation, take one of the TPG slots, and become an HCE!

The 5% Owner Override in a Top-Paid Group Environment

A common misconception among plan sponsors is that electing the Top-Paid Group protects all employees outside the top 20% from becoming HCEs.

5% Owners Completely Bypass TPG

The Top-Paid Group election is codified under IRC §414(q)(1)(B)(ii), which governs only the compensation test. It has no legal application to the 5% owner test under IRC §414(q)(1)(A).

• The Rule: A 5% owner is ALWAYS an HCE, regardless of whether the employer elects TPG, and regardless of where that owner ranks in compensation!
• Interaction with the TPG Cap:
  • If a 5% owner earns high compensation and ranks within the top 20%, they occupy one of the TPG slots under the compensation test and are also an HCE under the 5% owner test.
  • If a 5% owner earns modest compensation (e.g., $40,000) and ranks 80th out of 100 employees (far outside the top 20%), they are NOT in the Top-Paid Group. However, they are STILL an HCE by virtue of the independent 5% owner test!
  • Non-owner employees who rank outside the top 20% are shielded from HCE status; 5% owners can never be shielded by TPG.

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Calendar Year Data Election: IRS Notice 97-45

Under standard statutory rules, a plan operating on a fiscal plan year (e.g., July 1 through June 30) must determine HCE status by examining compensation paid during the 12-month fiscal lookback period (July 1 through June 30 of the preceding year). Because corporate payroll and tax reporting systems (Form W-2) operate on a calendar year basis (January 1 through December 31), extracting 12-month fiscal payroll data creates an enormous administrative burden.

Notice 97-45 Mechanics for Fiscal Year Plans

To eliminate this operational friction, the IRS issued IRS Notice 97-45, which authorizes employers to make the Calendar Year Data Election:

+---------------------------------------------------------------------------------------------------+
|                    IRS NOTICE 97-45 CALENDAR YEAR DATA ELECTION MECHANICS                         |
+---------------------------------------------------------------------------------------------------+
|                                                                                                   |
|   FISCAL PLAN YEAR (Determination Year):     July 1, 2025 through June 30, 2026                   |
|                                                                                                   |
|   [ DEFAULT STATUTORY LOOKBACK ]             [ NOTICE 97-45 CALENDAR DATA ELECTION ]              |
|   • Lookback Period:                         • Lookback Period:                                   |
|     July 1, 2024 through June 30, 2025         January 1, 2025 through December 31, 2025          |
|   • Requires manual 12-month mid-year          (The calendar year ending within the plan year)     |
|     payroll aggregation.                     • Perfectly aligns with Form W-2 Box 1 tax data!     |
|   • Lookback threshold applied based on        • Lookback threshold applied is the statutory      |
|     year lookback begins.                      rate for 2025 ($160,000).                          |
|                                                                                                   |
+---------------------------------------------------------------------------------------------------+

Critical Rules Governing the Calendar Year Data Election

1. Calendar Year Plans: For a plan that already operates on a calendar plan year, the Calendar Year Data Election has no operational effect on the lookback period, because the statutory lookback year is already the preceding calendar year.
2. 5% Owner Test Timing Unchanged: The Calendar Year Data Election modifies only the compensation test lookback period. It does NOT alter the 5% owner test! The 5% owner test continues to evaluate ownership during the actual plan determination year and the 12-month period immediately preceding the plan year.
3. Consistency Across Controlled Group: Under Notice 97-45, if an employer maintains multiple plans, the Calendar Year Data Election must be applied consistently to all qualified retirement plans of the employer that have plan years ending within the same calendar year.

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Plan Document Requirements to Adopt or Drop TPG

The Top-Paid Group rule is a permissive statutory election. It is not a default rule.

Plan Document Amendment Mandate

• Must be in the Plan Document: An employer cannot apply the Top-Paid Group rule operationally unless the written plan document explicitly contains Top-Paid Group language in its adoption agreement or basic plan document.
• Timing to Adopt or Drop: If a plan document currently does not contain a TPG provision, the plan sponsor must formally adopt an amendment electing TPG before the end of the determination year for which it is first effective.
• Controlled Group Uniformity: Treas. Reg. §1.414(q)-1T, Q&A-9(e) mandates that a TPG election must apply uniformly to all qualified retirement plans maintained by the employer (and all members of the IRC §414(b), (c), and (m) controlled or affiliated group). A sponsor cannot elect TPG for its salaried 401(k) plan while ignoring TPG for its hourly 401(k) plan.

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Comprehensive Worked Mathematical Case Study

Company Profile: Apex Engineering, LLC maintains a 401(k) plan operating on a calendar plan year. For the 2026 determination year, the employer's plan document contains a valid Top-Paid Group election. The lookback year is the 2025 calendar year, and the statutory compensation threshold is $160,000.

The census for the 2025 lookback year contains 15 employees with the following payroll and demographic records:

Step-by-Step TPG Mathematical Walkthrough:

Step 1: Count Total Workforce

Total individuals employed during the 2025 lookback year = 15 employees.

Step 2: Identify and Subtract Statutory Exclusions

Review each employee against statutory exclusions under Treas. Reg. §1.414(q)-1T, Q&A-9(b):

1. Elena: Age 20 (< 21) and Service 4 months (< 6 months) ──> EXCLUDED
2. Kevin: Service 5 months (< 6 months) and Hours 15 hrs/wk (< 17.5) ──> EXCLUDED
3. Megan: Service 3 months (< 6 months) ──> EXCLUDED
4. Liam: Age 19 (< 21), Service 2 months (< 6 months), Hours 12 hrs/wk (< 17.5) ──> EXCLUDED
5. Noah: Seasonal clerk working only 4 months (< 6 months per year) ──> EXCLUDED

$\text{Total Excluded Employees} = 5$ $\text{Net Workforce (Denominator)} = 15 - 5 = \mathbf{10 \text{ Employees}}$

Step 3: Calculate the 20% Headcount Cap

Multiply the net workforce by 20%:

$\text{TPG Headcount Cap} = 10 \times 0.20 = \mathbf{2 \text{ Employees}}$

(Note: Exactly 2.0 requires no rounding. The TPG headcount cap for the compensation test is exactly 2).

Step 4: Rank All Employees by Compensation and Apply the Cap

Rank ALL 15 employees by 2025 lookback compensation. Notice that Elena (Rank 3) is included in the ranking despite being excluded from the Step 2 denominator count!

• Rank 1: Sarah ($280,000) ──> In Top 2. Earns > $160,000. HCE (Also a 60% owner).
• Rank 2: David ($225,000) ──> In Top 2. Earns > $160,000. HCE.
• (The 2 TPG slots are now completely filled!)
• Rank 3: Elena ($210,000) ──> Earns > $160k, but outside Top 2! NHCE!
• Rank 4: Marcus ($195,000) ──> Earns > $160k, but outside Top 2! NHCE!
• Rank 5: Rachel ($185,000) ──> Earns > $160k, but outside Top 2! NHCE!
• Rank 6: James ($175,000) ──> Earns > $160k, but outside Top 2! NHCE!
• Rank 7: Olivia ($168,000) ──> Earns > $160k, but outside Top 2! NHCE!
• Rank 8: Brian ($162,000) ──> Earns > $160k, but outside Top 2! NHCE!
• Rank 9: Chloe ($85,000) ──> Earns < $160k, outside Top 2. BUT owns 8%! HCE under 5% Owner Test!
• Ranks 10 through 15: All earn < $160k and own 0%. All are NHCEs.

Comparative Analysis: With TPG vs. Without TPG

[!TIP] The Testing Miracle of TPG: By electing TPG, Apex Engineering reduced its HCE count from 9 down to 3. Six senior employees earning between $162,000 and $210,000 were reclassified as NHCEs. When these six high earners make 401(k) deferrals, their high contribution percentages dramatically raise the NHCE Average Deferral Percentage (ADP), allowing the owners (Sarah and Chloe) and executive (David) to max out their deferrals without failing the ADP test!

Common ASPPA QKA Exam Traps

• Exam Trap 1: The 'Excluded from Ranking' Fallacy: The single most frequent error on the QKA exam is excluding an employee from the Step 4 compensation ranking because they were excluded under Step 2. Remember: Step 2 exclusions define only the headcount cap. All employees who worked during the lookback year are ranked by compensation in Step 4!
• Exam Trap 2: Believing TPG Protects 5% Owners: An exam question describes a 10% owner whose compensation ranks 50th out of 100 employees in a company with a TPG cap of 15. Candidates mark the owner as an NHCE because they are outside the top 15. The 5% owner test operates completely independently of TPG. 5% owners are always HCEs.
• Exam Trap 3: The 0.50 Rounding Rule Boundary: Candidates frequently round down at 0.50 (thinking of normal integers) or always round up. Treas. Reg. §1.414(q)-1T, Q&A-9(b)(1) states that fractions of 0.50 or greater round up, while fractions strictly less than 0.50 round down. For 37 net employees, 37 × 0.20 = 7.4 ──> 7 employees. For 38 net employees, 38 × 0.20 = 7.6 ──> 8 employees.
• Exam Trap 4: Attempting Ad-Hoc Operational TPG Elections: A plan sponsor fails the ADP test at year-end, and the TPA attempts to retroactively apply TPG to make the test pass. Unless the written plan document already contained the TPG election prior to the end of the testing year, an operational TPG election is an operational qualification failure.
• Exam Trap 5: Controlled Group TPG Inconsistency: A parent corporation elects TPG for its corporate headquarters 401(k) plan but omits TPG from its manufacturing subsidiary's plan. Under Treasury regulations, TPG must be applied consistently across all qualified plans in the controlled group.