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, if key employees’ balances make up more than 60% of total account balances in the plan on the last day of the plan year, the plan is top-heavy.
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).
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., 2023 top-heavy status for a calendar year plan is determined on December 31, 2022). 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 2022 plan year are typically calculated after December 31, 2022, once all employee compensation is known).
Although the contribution is made for the prior (2022) year, it doesn’t change the top-heavy status for 2023 that was determined on December 31, 2022. Only the contributions made during 2022 will change or affect top-heavy status determined on December 31, 2023.
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 2022 and contributes profit sharing for the 2022 plan year on March 15, 2023, will have those profit-sharing contributions added to the top-heavy determination that is made for December 31, 2022. 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 allowed by the plan document.
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 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
The 401(k) plan is a calendar-year plan, which started in 2022. The plan permits deferrals and profit sharing contributions as a pro-rata contribution only (no matching or Safe Harbor contributions).
As of December 31, 2022, the plan is top-heavy: Key employees have deferred $20,000, which is 62.5% of total assets ($32,000). Employees are listed in the chart below, showing key and non-key status, deferrals, compensation for 2022, and projected employees and compensation for 2023.
In this scenario, the plan sponsor has several choices:
Contribute $31,500 as a pro-rata profit sharing contribution (6% of compensation) that would retroactively make the 2022 plan year not top-heavy and the 2023 plan year not top-heavy;
Contribute $6,750 as the top-heavy minimum contribution in 2022 and an unknown top-heavy minimum contribution in 2023 (for our example, we project an $11,250 top-heavy minimum next year after hiring two additional employees); or
Contribute a different amount. If the plan elects not to make a 6% contribution, it can still make a pro-rata contribution of a lesser amount plus any additional top-heavy minimum contribution for 2022, if applicable. If the plan contributes a 3% profit sharing contribution and there are no other employer contributions made to the plan for 2022, the 3% profit sharing contribution will meet the top-heavy minimum for 2022 but the plan will still be top-heavy for 2023.
In our example, we’ve projected that the company will make two additional hires in 2023 and retain all 2022 staff and compensation levels. All employees continue to be employed throughout 2022 and 2023 and are still employed on the last day of each applicable plan year. In this case, the total top-heavy contribution required for 2022 and 2023 would be $18,000. But note that those contributions only go to non-key employees. The owner of the business and the other key employee do not share in the top-heavy minimums.
If the owner contributes a 6% pro-rata profit sharing contribution of $31,500, there will be no top-heavy minimum contribution owed in 2022 and 2023, and the owner will get to share in the 6% contribution.
Note that profit sharing contributions required to make a plan not top-heavy can be a significant amount, depending on the participant makeup of the plan.
Additionally, in future years, profit sharing does not help your plan retroactively fix top-heavy statuses. For every year after the first plan year, the top-heavy status is determined by the plan balance as of December 31, and future contributions will not have an effect on the determination.
Example 2: Flat-dollar profit sharing formula – when profit sharing can prevent top-heavy status
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.
Here, the plan sponsor has several choices:
Contribute $7,500 as a flat-dollar profit sharing contribution ($1,500 per participant) that would retroactively make the 2022 plan year not top-heavy and the 2023 plan year not top-heavy; or
Contribute no profit sharing and $6,750 as the top-heavy minimum contribution in 2022 and an unknown top-heavy minimum contribution in 2023 (for our example, we project an $11,250 top-heavy minimum next year after hiring two additional employees); or
Contribute a different amount as profit sharing for 2022. Any amount the plan contributes as profit sharing below $1,500 per participant will generally count toward the top-heavy minimum contribution for 2022 (and could meet the minimum contribution). However, the plan will still be top-heavy and need to contribute a top-heavy minimum contribution for the 2023 plan year.
Because the flat-dollar contribution does not vary by compensation, it often requires less of an overall contribution to fix top-heavy status.
Note again that in future years, profit sharing does not help the plan retroactively fix top-heavy statuses. For every year after the first plan year, the top-heavy status is determined by the plan balance as of December 31 and future contributions will not have an effect on that date’s determination.
Example 3: Pro-rata employer contribution — when profit sharing cannot prevent top-heavy status
This 401(k) plan is very similar to the 401(k) plan from the examples above but has one less non-key employee. It is a calendar-year plan, which started in 2021 with a pro-rata profit sharing formula. The plan permits deferrals and profit sharing contributions only (no match or Safe Harbor contributions). As of December 31, 2022, the plan is top-heavy: Key employees have deferred $20,000 and this is 74% of total assets ($27,000). Employees are listed in the chart below, showing key and non-key status and compensation for 2022.
This plan can still make a profit sharing contribution but the profit sharing contribution cannot prevent top-heavy status. If the plan makes a significant profit sharing contribution equal to 18% of compensation, the top-heavy status of the plan will be decreased but will still be well over 60% (74,000/103,500 = 71.5%). The 18% contribution would meet the top-heavy minimum contribution for 2021 but the plan will still be top-heavy in 2023.
Note that the plan could contribute more than 18% as profit sharing but in doing so it would quickly reach the 404 deduction limit for employer contributions (25% of total compensation). In addition, once the contribution is increased to 25% or more of compensation, the key employee earning $200,000 would reach the 415 total contributions limit and not be able to receive the full profit sharing contribution.
Final considerations for plan sponsors
The decision to make an expensive 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 other compliance testing, such as ADP and ACP testing. Plus, if no additional employer contributions are made beyond the Safe Harbor harbor contributions, no Top-Heavy test or minimum corrections are required.
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.