401k Top Heavy Test: What You Need to Know

The 401k top heavy test is a crucial aspect of ensuring your retirement plan complies with the IRS regulations. Your plan may be considered top-heavy if it favors highly compensated employees, which can lead to penalties.

A top-heavy plan must undergo a test to determine if it's meeting the minimum required benefit for non-highly compensated employees. This test is usually conducted annually.

To pass the test, the plan must meet a minimum ratio of benefits for non-highly compensated employees to highly compensated employees. The ratio is calculated based on the average annual compensation of highly compensated employees compared to non-highly compensated employees.

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A 401(k) plan is a type of employer-sponsored retirement savings plan that allows employees to contribute a portion of their paycheck to a tax-deferred investment account.

These plans are designed to help employees save for their future, and they often come with employer matching contributions.

The plan's assets are typically made up of employee contributions, employer matching contributions, and investment earnings.

A top-heavy plan is a type of 401(k) plan where the owners and highly paid employees own more than 60% of the plan assets.

The top-heavy ratio is tested every year based on the account balances on the last day of the prior plan year.

If the top-heavy ratio exceeds 60%, the employer must pay a minimum 3% benefit to the accounts of the lower paid employees.

Here's a simple way to check if a plan is top-heavy:

If a plan is found to be top-heavy, the employer must take corrective action to bring the ratio back under 60%.

Nondiscrimination testing is a crucial aspect of 401(k) plans, and it's essential to understand how it works. All 401(k) plans must pass a series of annual IRS nondiscrimination testing to ensure that the plan is fairly benefiting all participants.

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Highly-compensated employees, either owning more than 5% of the company sponsoring the retirement plan or earning at least $155,000 in the prior year, are subject to nondiscrimination testing. If a plan unfairly benefits highly-compensated employees, the plan administrator is required to take corrective action.

The IRS wants to ensure that plans are not unfairly benefiting highly-compensated employees over non-highly-compensated employees. To achieve this, nondiscrimination tests are required to determine if a retirement benefit plan is unfairly benefiting highly-compensated employees.

Multiple factors determine whether a company passes nondiscrimination testing and how it can be corrected. Plan administrators must carefully review their compliance testing package to determine if a minimum contribution will be due in the following year.

Here's a breakdown of the types of plans that are exempt from top-heavy testing:

However, if you don't make these minimum contributions to employees' accounts, it won't be exempt.

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If your 401(k) plan has a safe harbor provision, you're in luck - it might be exempt from top-heavy testing. This means you won't have to worry about making additional contributions to non-highly compensated employees.

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A safe harbor 401(k) plan that receives only elective deferrals and safe harbor minimum contributions is exempt from top-heavy testing. This includes matching contributions up to 4% of salary, non-elective employer contributions of 3% of salary to every account, and contributions under a qualified auto-enrollment plan.

To qualify for this exemption, your plan must meet one of the following requirements: providing matching contributions up to 4%, providing non-elective contributions of 3% of salary for every account, or making contributions under a qualified auto-enrollment plan up to a 3.5% match or 3% non-elective.

Here are the safe harbor minimum contributions that are exempt from top-heavy testing:

However, if you make additional employer contributions beyond these safe harbor contributions, your plan will be subject to top-heavy testing.

Key employees play a crucial role in determining the minimum contributions for your 401(k) plan. To determine who is a key employee, you'll need to consider their compensation and ownership status.

For the 2024 tax year, an officer making over $220,000 is considered a key employee. This amount is adjusted annually for inflation, so it's essential to check the current threshold.

A non-key employee, on the other hand, is anyone who doesn't meet these criteria.

Here's a breakdown of the key employee categories:

If a key employee later becomes a non-key employee, they should be excluded from your test.

Key Employees are those who hold significant roles or ownership in your business. An officer making over $220,000 is considered a key employee.

To determine if an employee is key, look at their compensation. If they make over $220,000, they're likely a key employee. This amount is adjusted annually for inflation.

Key employees also include business owners holding more than 5% of the stock or capital, or owners earning over $150,000 and holding more than 1%. This means if you have a family member who owns a significant amount of shares, they might be considered a key employee.

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Here are some key employee categories:

Keep in mind that if someone becomes a non-key employee, they should be excluded from your test. This can happen if they sell their interest or are no longer an officer.

Minimum contributions for non-key employees are a crucial aspect of plan participation. The minimum contribution is generally 3% of total compensation for the year.

This percentage is not just based on the dates of plan participation, but on the entire year's compensation. If the highest contribution percentage for a key employee is less than 3%, non-key employees receive the highest percentage for a key employee instead.

Elective deferrals are only considered for key employees when determining this average contribution. Non-key employees receive the minimum contribution if they were employed on the last day of the year.

Here are the key points to remember about minimum contributions for non-key employees:

Vesting is a critical concept in employee benefits, and it's essential to understand the different types. Vesting means ownership, and it's a way to ensure that key employees have a stake in the company's success.

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In the context of key employees, minimum top-heavy contributions must be 100% vested within six years. This is a regulatory requirement to prevent excessive benefits for a select few.

There are two minimum vesting schedules: three-year cliff vesting and six-year graded vesting. The three-year cliff vesting schedule requires 100% vesting upon completing three years of service.

Here's a breakdown of the two vesting schedules:

The six-year graded vesting schedule is a more gradual approach, but it still meets the regulatory requirement of 100% vesting within six years.

If your 401(k) plan is top-heavy, you'll need to take corrective action. The employer must make a corrective contribution that includes lost earnings to the non-key employees.

This contribution is generally 3% of compensation and then adjusted for plan earnings through the date of correction. The contribution must be the lesser of the highest HCE benefit (including deferrals) for the year, or 3% of compensation.

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Employers have a deadline to make these corrective contributions, which is the end of the plan year following the year in which the contributions are due. However, the deadline to receive a deduction on an annual corporate return may be sooner.

If corrective employer contributions are not made on time, an operational failure has occurred. The plan may make corrections under the Self Correction Program or the Voluntary Correction Program, or it could be in jeopardy of losing its qualified status.

Employer J, a husband and wife business, learned this the hard way when they discovered their plan was top-heavy for the 2020 and 2021 plan years. They didn't make minimum top-heavy contributions, but fortunately, they were able to correct the mistake using one of the IRS correction programs.

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Safe harbor 401(k) plans are exempt from top-heavy testing if they receive only elective deferrals and safe harbor minimum contributions.

To qualify for this exemption, the plan must meet one of the following requirements:

Safe harbor plans also allow employees to max out their contributions without refund concerns.

Adding a safe harbor non-elective provision to a plan can be done retroactively.

The required nonelective contribution minimum will vary depending on when the provision is added.

Safe harbor matching provisions generally must be added 30 days before the start of the year, but safe harbor nonelective contributions can be added mid-year and even into the next plan year (as long as the contributions are made retroactively to the first day of the plan year).

To avoid top-heavy status, consider these tips and best practices.

Encourage non-key employees to increase their contributions by educating them on the importance of saving for retirement. Guideline provides resources on participant education, such as their employee Help Center.

Request that key employees reduce or stop their contributions, but be careful not to offer any incentives or disincentives that may affect their decision to contribute to the plan.

Making a profit sharing contribution in your first year of having a 401(k) plan may help you avoid top-heavy status for both the first and second years.

Removing the service requirement for your plan can help by allowing previously ineligible employees to participate.

A small match can incentivize participation - for example, a 25% match of up to 8% of contributions can encourage participants to increase their contributions to 8% or more.

A safe harbor non-elective contribution mid-year can help avoid top-heavy minimums for the applicable plan year, but note that the contribution will need to be made to all employees for all eligible compensation.

If your plan is expecting to exceed top-heavy limits by the end of the year, consider adding a safe harbor non-elective contribution to avoid minimums for the applicable plan year.

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If you have related businesses or plans, the tax law may require you to consolidate them for top-heavy testing. This can be a complex process, especially if you and your spouse own multiple businesses.

You may have to combine plans if you sponsor more than one, and at least one key employee participates in each plan. This means that even if you have separate plans for different businesses, they may need to be merged for top-heavy calculations.

Combining related businesses can also affect your top-heavy ratio, which is used to determine whether your plan is considered top-heavy. This ratio takes into account the combined plan assets and the number of participants in all related plans.

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If your 401(k) plan is top heavy, you'll need to prepare for the consequences. Many small plans cannot pass the top heavy test.

You can ask your 401(k) provider to determine your plan's top heavy status. Finding out your plan is top heavy down the line is never a welcome surprise.

A safe harbor contribution can help alleviate top heavy issues, costing about the same as a top heavy minimum contribution. This can be a lifesaver for small business owners.

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