The Internal Revenue Service (IRS) requires all 401(k) plans to undergo compliance testing after the end of each year. These tests are implemented to ensure a plan does not unfairly favor owners and highly compensated employees and that it stays within IRS-required limits for contributions.
The test that often has the largest consequence for small businesses is the Top-Heavy test.
Here’s what you should know about the Top-Heavy test and best practices to avoid Top-Heavy status.
What is the Top-Heavy test?
The goal of Top-Heavy testing is to ensure that if “key employees” hold more than 60% of the total account balances by value in a 401(k) plan, that non-key employees receive a minimum contribution under the plan.
Key employees are defined as:
An officer making more than $215,000 for 2023 (or $200,000 for 2022), or
An employee of the company who in the current year
Owns more than 5% of the business, or
Owns more than 1% of the business and makes over $150,000 for the plan year
Note: Family attribution rules may apply. This means an employee who is the spouse, parent, child or grandparent of someone with more than 1% ownership and is making over $150,000 for the plan year may be a key employee.
Top-Heavy contributions can be among the costliest of testing contributions. Therefore, it is crucial to have an understanding of this test and how it may impact your business.
How is Top-Heavy testing completed?
Top-Heavy testing assesses account balances of key employees as a percentage of the total plan assets. A plan is “top-heavy” if the account balances of key employees represent more than 60% of the account balances of all employees. Plan balances are adjusted to exclude unrelated rollovers* and most balances of terminated employees, but include loans and early distributions.
Top-Heavy status is determined using account balances on the determination date, which is the last day of the year for new plans and on the last day of the prior year for all plans after their first year. First-year plans must also include contributions made for the first plan year but not allocated until after December 31.
What happens if my plan is at risk of being top-heavy
If you received a warning that your plan may be at risk of being top-heavy, you should first ensure that Guideline has the correct information on file regarding your key employees.
Consider reviewing your company information regularly to confirm that all key employees, including officers, owners, children, and owners’ spouses have been reported correctly. You may also wish to review your Guideline roster to ensure all employee statuses (active, dismissed, etc.) are up to date.
Then, check out our article on methods to increase your chance of passing the Top-Heavy test for helpful tips.
How to correct a top-heavy plan
If your plan is still considered top-heavy by the determination date, you must make a contribution to all non-key employees who are employed on the last day of the year (this is standard for Guideline plans).
The Top-Heavy minimum contribution for each non-key employee is the lesser of:
Three percent, or
The highest contribution percent of any key employee (including deferrals that are not catch-up contributions)
The Top-Heavy minimum contribution can be met by employer matching, profit sharing, safe harbor or qualified non-elective contributions (QNECs).
Note that while elective deferrals are included when determining the highest contribution percent of any key employee, they are not included when determining if a non-key employee has received the minimum contribution. Also, note that Top-Heavy contributions can be subject to vesting.
Special cases
The Top-Heavy test can work in surprising ways depending on the facts of your plan. A few special cases are outlined below.
Only key employees
If your plan consists only of key employees, the plan will by default, exceed the Top-Heavy limit. In this case, because there are no non-key employees, no contributions are needed for the year the plan is in Top-Heavy status. However, if a non-key employee is hired during the year that a plan is top-heavy, or perhaps even in subsequent years, these non-key employees may need to receive Top-Heavy contributions, as long as they are eligible for your 401(k) as of the determination date.
If you plan to hire non-key employees, you can set up a 12-month service requirement to delay them from becoming eligible immediately. As a result, they will not be included in the Top-Heavy test for the current year.
Owner draws
If your company entity type allows owners and/or key employees to elect owner draws, please beware that a late or year-end owner draw may drastically increase the Top-Heavy ratio for the plan.
Even if your plan has been passing the Top-Heavy test for the majority of the year, an owner who gives themselves an end-of-year 401(k) contribution to maximize their deferrals may tip the key asset balance above 60%. Guideline would not be able to detect or monitor unexpected owner draws.
Instead, owners should contribute consistently throughout the year via periodic draws, observe non-key employee deferral rates, and adjust their deferrals accordingly.
Short plan year/end-of-year bonuses
First-year plans joining Guideline in the fall or winter months or plans intending on making a large year-end contribution (such as a year-end bonus) are at a higher risk of exceeding the Top-Heavy limit. This is because the plan will have a shorter time span to make contributions, thus making preventative measures more difficult.
Many owners or key employees intend to contribute as much as possible and, as such, decide to make large year-end contributions. However, as a plan administrator, it can be helpful to get in the habit of contributing consistently throughout the year, consider starting the plan earlier in the year, or choose to make a contribution to employees to ensure your plan is not top-heavy.
High proportion of owners
Top-Heavy testing can be particularly difficult for small businesses with a high proportion of owners. Changes in employees can also make a significant difference in Top-Heavy testing, so keeping ownership information up to date is imperative. For example, having a large number of key employees can skew the Top-Heavy results past the threshold of 60%.
How to avoid Top-Heavy testing
Safe Harbor plans are designed to ensure plan benefits are fair and don’t discriminate in favor of business owners, officers, and highly paid employees. Therefore, employers who adopt these plans are generally exempt from required annual nondiscrimination testing, including the Top-Heavy test as well as the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests.
You can learn more about the benefits of a Safe Harbor plan here.
*Unrelated plan balances rolled over to Guideline are not included in adjusted balance.