The goal of top-heavy testing is to ensure that a 401(k) plan does not unfairly favor owners and “key employees.” Key employees are certain owners or officers of the employer sponsoring the plan.
A plan is top-heavy if the account balances of contributions in the plan are more heavily weighted to key employees. Specifically, for every year except the first plan year, if key employees’ balances make up more than 60% of total account balances in the plan on the last day of the prior plan year, the plan is top-heavy for the current plan year.
If a plan is top-heavy, an employer may be required to make top-heavy contributions, which are often quite costly. However, some first-year plans that would otherwise have to contribute top-heavy minimum contributions may be able to avoid this by making a profit sharing contribution.
In order to understand this special rule, it is important to know how top-heavy determinations are made and how the first year is different from other plan years.
Understanding top-heavy minimum contributions
If a plan is top-heavy, it may owe top-heavy minimum contributions depending on the other employer contributions made to the plan. The top-heavy minimum contribution is equal to the lesser of:
3% of total annual compensation for non-key participants employed on the last day of the plan year, or
The highest contribution percent of any key employee (the contribution percentage includes any elective deferrals that are not catch-up contributions as well as any employer contributions they receive).
This means if a plan makes a 3% profit sharing contribution, and the contribution is calculated using full-year compensation versus post-entry date compensation, that contribution would generally meet top-heavy minimum contributions and no additional top-heavy minimum contributions may be required for that plan year.
In addition, there is a special rule for safe harbor plans: If a plan is safe harbor and makes no non-safe harbor employer contributions to the plan, top-heavy minimum contributions will not be required.
How top-heavy status applies after the first plan year
In all years after the first plan year, top-heavy status is determined based on the balance in the plan as of December 31 of the prior year (e.g., 2025 top-heavy status for a calendar year plan is determined on December 31, 2024). It’s common that contributions for a particular plan year are actually contributed after the end of the plan year (e.g., profit sharing contributions for the 2024 plan year are typically calculated after December 31, 2024, once all employee compensation is known).
Although the contribution is made for the prior (2024) year, it doesn’t change the top-heavy status for 2025 that was determined on December 31, 2024. Only the contributions made during 2024 will change or affect the top-heavy status determined on December 31, 2024.
These general rules do not apply to the first plan year.
How top-heavy status applies for the first plan year
The first plan year counts contributions given in the following year to determine the first year’s top-heavy status if those contributions are for the first year. Additionally, top-heavy status in the first year uniquely applies for two plan years – the first plan year and the second plan year.
For example, a plan that starts in 2024 and contributes profit sharing for the 2024 plan year on March 15, 2025, will have those profit-sharing contributions added to the top-heavy determination that is made for December 31, 2024. This means some plans may be able to use additional contributions for the first plan year to avoid or prevent having a top-heavy status in the first and second years. This opportunity can be impacted positively or negatively depending on the type of workforce (the number of key versus non-key employees and their respective compensation amounts) and the type of profit sharing used.
How to use profit sharing contributions to prevent top-heavy status for the first (and second) plan years
Some plans that are projected to be top-heavy in the first plan year may be able to decide whether to 1) use a profit sharing allocation to avoid top-heavy contributions for both years (if reasonable and possible) or 2) remain top-heavy and fix the issue with a top-heavy minimum contribution (if applicable). This decision only applies to first-year plans.
The choice can be quite difficult for several reasons:
Fixing top-heavy status with profit sharing is typically more expensive than providing a top-heavy minimum for that first year (profit sharing is generally provided to all participants while top-heavy minimums go to non-key participants only);
The full top-heavy minimum contribution needed to fix the top-heavy status for both years won’t be known until the end of the second year (top-heavy minimums depend on the non-key employee compensation as of the end of each plan year and the amount of employer contributions received by those employees); and
Top-heavy minimum contributions only go to non-key employees. Therefore, you may want to consider the benefits of paying more for a contribution that you can share in – one that also provides assurance that you won’t be required to make a top-heavy minimum contribution for the following year.
Guideline can help with this decision by providing guidance on minimum contributions necessary to avoid top-heavy status for first-year plans and if profit sharing can prevent a top-heavy status. The options for any plan will depend on the makeup of that plan, the profit sharing formula, and the goals of the employer.
This article focuses on plans with a pro rata (sometimes called comp to comp) profit sharing formula, where all participants get the same percentage of compensation, or a fixed dollar formula, where all participants get the same dollar amount.
Examples of when profit sharing might fix top-heavy plans
The following are examples that show two instances where profit sharing can help fix top-heavy status and one where it can’t.
Example 1: Pro rata profit sharing formula – when profit sharing can prevent top-heavy status in the first year
The 401(k) plan in this example is a calendar-year plan that started in 2024. Deferrals are permitted, and the plan has an annual pro rata profit sharing option, but there are no matching or safe harbor contributions.
As of December 31, 2024, the plan is 64.71% top-heavy because the account balances of the key employees add up to $22,000 of the total $34,000 plan balance. The participants are listed in the chart below with their status as a key or non-key employee, their 2024 compensation, and their year-end balances.
In this scenario, the plan sponsor has a few options:
Contribute $6,750 as a 3% top-heavy minimum contribution (THMC) for 2024 for the non-key employees only, which has the added benefit of reducing the percentage of the key employees’ portion of the total for 2024 to 53.99%. The plan will no longer be top-heavy for the 2025 plan year, but the key employees receive none of the 2024 top-heavy allocation.
Contribute $18,000 as a pro rata profit sharing contribution (4% of compensation) to all participants, including the key employees, to decrease the percentage of the key employees portion of the total for the first year to 59.62%. The plan will no longer be top-heavy for the 2024 or the 2025 plan year, and the key employees will receive half of the 2024 profit sharing allocation.
Contribute a different percentage or amount as a pro rata profit sharing contribution. Any percentage higher than 4% and the plan will no longer be top-heavy for the 2024 or the 2025 plan year. Anything much less and the plan may remain top-heavy for both years and the non-key employees will have to receive at least the 3% THMC required.
For a first year plan, profit sharing may be less expensive than the THMC, or it may end up being significantly higher, depending on the number of key employees versus non-key employees as well as the annual compensation for the first year. Note: Profit sharing cannot be used to retroactively fix a top heavy plan after the first year.
Example 2: Flat-dollar profit sharing formula – when profit sharing can prevent top-heavy status in the first year
In this scenario, the facts are the same as in the above example (same compensation amounts and projections, number of key versus non-key employees, etc.) but the plan has a flat-dollar contribution formula instead of pro rata.
In this scenario, the plan sponsor also has a few options:
Contribute $6,750 as a 3% top-heavy minimum contribution (THMC) for 2024 for the non-key employees only, reducing the percentage of the key employees’ portion of the total for 2024 to 53.99%. The plan will no longer be top-heavy for the 2025 plan year, but the key employees receive none of the 2024 top-heavy allocation.
Contribute $8,750 as a flat-dollar profit sharing contribution – $1,750 for all eligible participants, including the key employees – to decrease the percentage of the key employees portion of the total for the first year to 59.65%. The plan will no longer be top-heavy for the 2024 or the 2025 plan year, and the key employees will receive 40% of the 2024 profit sharing allocation.
Contribute a different percentage or amount as a flat-dollar profit sharing contribution. Any amount $1,750 or higher and the plan will no longer be top-heavy for the 2024 or the 2025 plan year. Anything much less and the plan may remain top-heavy for both years and the non-key employees will have to receive at least the 3% THMC required.
For a first year plan, a flat-dollar profit sharing may be less expensive than using a pro rata formula, depending on the number of key employees versus non-key employees as well as the annual compensation for the first year. Note: Profit sharing cannot be used to retroactively fix a top heavy plan after the first year.
Example 3: Pro rata employer contribution — when profit sharing cannot prevent top-heavy status
Like the other two examples, this 401(k) plan is a calendar-year plan that started in 2024. Deferrals are permitted, and the plan has an annual pro rata profit sharing option, but there are no matching or safe harbor contributions.
As of December 31, 2024, the plan is 71.05% top-heavy because the account balances of the key employees add up to $27,000 of the total $38,000 plan balance. The participants are listed in the chart below with their status as a key or non-key employee, their 2024 compensation, and their year-end balances.
This plan can still make a profit sharing contribution (in the example, a 5% pro rata allocation will total $26,250, so the key employees will get more than 57% of the profit sharing total and the allocation covers the top-heavy minimum contributions required for the non-key employees) but the plan will remain 65.37% top heavy for the first and second plan year.
Final considerations for plan sponsors
The decision to make a profit sharing contribution to prevent top-heavy status isn’t easy. If you expect to hire additional non-key employees in the second year of the plan, it may be worthwhile to make the contribution and know that a top-heavy minimum contribution will not be required for the next year.
Changing to a safe harbor plan design may also be worth considering. 401(k) plans with safe harbor provisions are exempt from certain compliance tests, like the ADP and ACP tests. Plus, if no additional employer contributions are made beyond the safe harbor contributions, no minimum corrections are required if the plan is top-heavy.
Safe harbor matching provisions generally must be added 30 days before the start of the year but safe harbor nonelective contributions can be added up until the last day of the plan year following the plan year in which it is effective (as long as the contribution is made retroactively to the first day of the effective plan year). You can add a safe harbor provision to your plan for the coming year by contacting Guideline support.
To allow adequate time for amending plan documents and providing required notices to participants (at least 30 days prior to the new year), please start the process before November 1 of the year before you wish to add a safe harbor match.