This article builds upon the Compliance Testing Basics article by focusing on the test that has the largest consequence for small businesses: the top-heavy test. It is described below, along with recommendations to improve your chances of passing.
- Defining a Key Employee
- Testing Method
- Pass It
- Fix it
- Special Case 1: Only Key Employees in Plan
- Special Case 2: Owner Draws
- Special Case 3: Short plan year / End of year bonuses
- Special Case 4: High Proportion of owners
- How a Safe Harbor Plan can help
Top-heavy testing has similar goals to the ADP/ACP tests, but it is concerned with plan balances as opposed to plan contributions. The goal of top-heavy testing is to ensure key employees and owners do not hold a majority of the plan balance, which could be seen as discriminatory against other employees. Top-heavy corrections are usually the most costly corrections when it comes to non-discrimination testing. Therefore, it is crucial that you have an understanding of this test. Please note that if you have a Safe Harbor plan, you do not need to perform this test every year.
Defining Key Employee
The top-heavy test uses Key Employees in calculations. A Key Employee is:
- An officer making over $185,000 for 2020; ($180,000 for 2019, $175,000 for 2018, and $170,000 for 2015 through 2017), or
- An employee of the company in the current year who:
- 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: Familial attribution rules may apply. This means an employee who is the spouse, parent, child or grandparent of a greater than 1% owner and is making over $150,000 for the plan year may be a Key Employee. A Non-Key Employee is everyone else.
Note: If you have received a warning that your plan may be at risk for being top-heavy, you should first ensure that Guideline has the correct information on file about your Key Employees. Review your Company Information regularly to confirm that all Key Employees, including officers, owners, children, and spouses of owners have been correctly reported. Review your Guideline Roster to ensure all employee statuses (active, dismissed, etc. ) are up to date. You can visit this article to learn more about how company ownership and familial relations should be reported for your plan.
Top-heavy testing assesses account balances of key employees as a percentage of the total plan assets. A plan is top-heavy if account balances of key employees represent more than 60% of the account balances of all employees. Plan balances are adjusted to exclude rollovers* and balances of terminated employees but include loans and early distributions.
Top-heavy status is measured on 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. This is called the determination date. Also, first-year plans can receive the benefit of certain contributions that are accrued but not yet paid. For every year past the first year, the cash basis accounting method is used to assess balances at the end of the year.
*Unrelated plan balances rolled over to Guideline are not included in the adjusted balance
A plan that fails the top-heavy test in the first year is also top-heavy for the following year. For example, if Key Employee balances equal more than 60% of the total account plan balance on the determination date of 12/31/2020, the plan is said to be top-heavy for the 2021 year. The plan will then need to make a Top-Heavy Minimum Contribution (THMC) of 3% to all employees who were eligible on 12/31/2021 or make a certain type of contribution that can be accrued to 12/31/2020 to ensure the plan is not top-heavy. For all plans after the first year, the top-heavy test is forward-looking and the determination is made using cash basis. This means the determination date is the last date of the prior year, and the accrued contributions and balances in the plan account at that time will determine the top-heavy status.
Because of this, the costs of failing a Top Heavy test can add up and become expensive for a plan. This can be avoided by amending the plan to a Safe Harbor design, such as a Safe Harbor match or Safe Harbor Non-Elective contribution.
The below graph illustrates an example where:
- A plan’s key employee holdings exceeded 60% as of December 31, 2019.
- As a result, the plan is top-heavy for the 2020 year. A 3% THMC is due by the end of 2021 for the 2020 plan year.
Top-heavy is a cumulative test. This means that if your plan exceeds top-heavy in the first year, there will be consequences in the following year(s) as well. Depending on how your plan is structured and if you make changes to the plan, you may be able to avoid top-heavy issues moving forward by following the steps below. Some of the steps that you will use to address top-heavy issues are the same as those used to address ADP/ACP testing. If your plan is currently outside the permitted ratio, you can close the gap by:
- Encouraging non-key employees to increase contributions. You can do this by educating employees on the importance of saving for retirement. Guideline provides a wealth of resources on participant education, starting with our Help Center for participants as well as our helpful Video Library. We even offer webinars for new participants! Contact Guideline Support for more information.
- Requesting that key employees reduce or stop their contributions.
- A combination of the two options above.
- If it is your first year having a 401(k) plan, you may be able to make a Profit Sharing Contribution to avoid the plan’s top-heavy status for both the first and second years.
You may also:
- Remove the service requirement for your plan. This may help by allowing previously ineligible employees to participate.
- Add a small match to incentivize participation. For example, a match of 25% up to 8% will encourage participants to increase their contributions to 8% or more in order to take full advantage of the company match. Compared to the Top Heavy Minimum Correction of 3% (which must go to all eligible employees and not just those contributing) plus failing the test for an additional year, this is a small price to pay!
- Add a Mid-Year Safe Harbor Match to save your plan. If your plan is currently expecting to exceed Top Heavy limits by the end of 2020, you may consider adding a Safe Harbor non-elective contribution mid-year (which may be allowed under the SECURE act). This will prevent your plan from being top-heavy for the year entirely!
What Won't Pass Testing:
- Taking a disbursement. If your plan is currently exceeding limits, taking a disbursement mid-year will not change the results. The IRS expressly prohibits this.
- Removing the Key Employee from the Roster. Even if a Key Employee is terminated or moves their funds elsewhere, test results are based on the determination date and all contributions made up to their date of dismissal will be taken into account for testing.
- Canceling/Terminating the plan. Upon plan termination, all Guideline plans undergo an Account Review, where we will address compliance testing per its current standing. You would need to make contributions prior to the termination to comply with IRS rules.
- Taking a reversal. Making a correction for funds that have already been contributed is not an IRS-permissible method to withdraw funds.
How To Fix It
If no action is taken upon receiving notices from Guideline, and employees continue to contribute at the same rates for the rest of the year, your plan would be considered top-heavy. The correction method is generally for the employer to make a contribution to all non-key employees who are employed on the last day of the year.
These top-heavy contributions must equal the following:
- 3% of each non-key employee’s W-2 income, or
- The highest contribution percent of any key employee. In an instance where all key employees in a plan opt out for the plan year and no key employees participate at all, then no corrections would be owed since the highest key employee percentage would be 0%.
If non-key employees receive matching, profit sharing, or qualified non-elective contributions (QNECs), note these can count toward the top-heavy minimum contribution.
Note that top-heavy contributions can be subject to vesting.
Special Case 1: Only Key Employees in Plan
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 corrections are needed for the year the plan fails. However, keep in mind that if a non-key employee is hired during the year that a plan is top-heavy or perhaps even subsequent years, these non-key employees may need to receive corrective contributions in the future, as long as they are eligible 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. This way, they will not be included in the top-heavy test for the current year. Alternatively, you could consider switching to a Safe Harbor Plan Design to minimize the need for corrective contributions.
Special Case 2: 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 to exceed limits. Even if your plan has been passing top-heavy for the majority of the year, an owner who gives himself/herself 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 surprise owner draws. Owners should contribute consistently throughout the year via periodic draws, observe non-key employee deferral rates, and adjust their deferrals accordingly.
Special Case 3: 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 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 and thus making preventative measures more difficult. Many owners or key employees intend to contribute as much as possible and, as such, decide to make a large year end contribution. Owners should make a habit of contributing consistently throughout the year, considering starting the plan earlier in the year, planning on making a contribution to employees to ensure their plan is not top-heavy, or setting up a Safe Harbor plan to be exempt from all non-discrimination testing if they intend to maximize first year contributions.
Special Case 4: 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 big difference in top-heavy testing, so keeping ownership information up-to-date is important. For example, having a large number of Key Employees can skew the Top Heavy results past the passing threshold of 60%. Guideline will be in a better position to assist you with mitigation strategies when the risk is identified early and when owners are educated about top-heavy testing.
Use a Safe Harbor Plan Design and Never Worry
Although you will still need to pass coverage testing, 401(k) plans with Safe Harbor provisions are exempt from ADP, ACP, and top-heavy tests. Safe Harbor provisions must be added 30 days before the start of the 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 1st.
Because the top-heavy test can be confusing to navigate, Guideline can assist with implementing a compliance strategy or crafting a solution that’s right for your company. Guideline specialists are ready to discuss your options with you. Contact us today.