401(k) Nondiscrimination Testing: Balancing a Top Heavy Determination

Mar 18, 2022

A top-heavy determination can cast a bigger shadow than it should for those who may not be aware of the rules surrounding this nondiscrimination test for qualified retirement plans. A plan is considered top-heavy if more than 60% of plan assets are held by the business owner and other “key” employees. Because business owners tend to contribute more to the retirement plan than lower-paid employees, small employer plans are more likely to be top-heavy.

For example, businesses that have more partners than employees (e.g., professional firms) and businesses with a large workforce of lower paid employees or high turnover (e.g., businesses in the food or hospitality industries) may be especially at risk. But, under the plan compliance rules, being top heavy is acceptable so long as the employer makes a minimum contribution for the non-key employees.

The cost of this mandatory contribution is something business owners must plan for, but most probably don’t need to be overly anxious about this aspect of plan compliance. Most plans already meet the minimum contribution requirement and, if they don’t, the cost of the contribution can be mitigated in several ways. 

Who are the key employees?

Key employees are defined as employees who, for the plan year that includes the determination date:

  • Own more than 5% of the business,
  • Own more than 1% of the business and earn more than $150,000, or
  • Are officers of the business and earn more than the applicable limit ($200,000 for 2022 and$185,000 for 2021).

In measuring ownership, employees must include stock owned by their spouse, children, grandchildren, and parents.

What account balances are counted?

The top-heavy test considers the account balances of all key and non-key employees as of the last day of the previous plan year. The account balances of former employees who did not perform service for the business in the prior year are not included. To prevent plans from manipulating plan assets to avoid top-heavy status, the rules apply a look-back period for including plan distributions in the test. These amounts must generally be added back:

  • Most in-service distributions made during the prior five plan years
  • Distributions made upon termination, death or disability during the prior plan year

What happens when a plan is top heavy?

The determination of whether a plan is top-heavy for the current plan year is made as of the last day of the prior plan year. For example, if key employees hold more than 60% of the account balances as of December 31, 2021 (for a calendar-year plan), the plan will be considered top-heavy for 2022. This means that the plan must generally make at least a 3% contribution to non-key employees for 2022. If the employer does not make the minimum contribution, the plan may lose its qualified status. Plan sponsors can correct this failure under the IRS Employee Plans Compliance Resolution System (EPCRS).

How could an employer potentially reduce the required top-heavy contribution?

Employers with top-heavy plans cannot avoid making a 3% contribution to keep the plan in compliance, but there are several factors to keep in mind that can potentially assuage employers’ fears of having to make an additional, large contribution to the plan.

  1. If an employer is already contributing to the plan, no further contribution is required if non-key employees are receiving 3% (e.g., if a matching contribution is made, non-key employees must be deferring enough to receive at least a 3% match).

  2. An employer can use plan forfeitures to fund the top-heavy contribution.

  3. The minimum contribution may be less than 3% if the largest percentage that’s been allocated on behalf of any key employee for that year is less than 3%. (This is rare with a 401(k) plan because salary deferrals made by key employees are included in determining the largest percentage allocated to a key employee, but it may be helpful to a profit-sharing plan.)

  4. The plan can be designed with any or all the following provisions: 
    • Provide only the minimum top-heavy contribution
    • Allocate the contribution only to non-key employees (rather than all employees)
    • Allocate the contribution only to non-key employees who are employed on the last day of the plan year
  5. The 3% contribution is calculated based on each non-key employee’s compensation for the year. If most non-key employees work part-time or earn a lower wage, the 3% contribution may not add up to as much as anticipated.

  6. A plan designed to meet the safe harbor 401(k) plan requirements satisfies the top-heavy requirement, so long as the employer contributes only the required safe harbor contribution.

This material has been prepared for informational purposes only. It is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Consult your own tax, legal and accounting advisors before making any decisions. Newport and its affiliates do not provide tax, legal or accounting advice.



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