Key Takeaways
Top-heavy testing is required by the IRS to be conducted to ensure that a 401(k) plan does not favor highly-compensated employees (HCEs) over non-highly compensated employees.
A business can avoid top-heavy testing by adopting a safe harbor 401(k) plan and meeting certain annual conditions.
If a business fails top-heavy testing, they must take corrective action to the plan by making contributions to non-key employees to bring the plan back into compliance.
What is nondiscrimination testing?
All 401(k) plans must pass a series of annual IRS nondiscrimination testing. Because there are substantial tax benefits through 401(k) retirement savings plans, the IRS wants to ensure plans are fairly benefiting all participants. That’s why nondiscrimination tests are required to determine that a retirement benefit plan does not unfairly benefit highly-compensated employees over non-highly-compensated employees. Highly-compensated employees either own more than 5% of the company sponsoring the retirement plan or earn at least $155,000 in the prior year (as indexed).
If a plan unfairly benefits highly compensated employees, the plan administrator is required to take corrective action to bring the plan into compliance. The corrections include reducing the benefits towards highly-compensated employees or providing additional benefits to non-highly compensated employees. However, multiple factors determine whether a company passes nondiscrimination testing and how it can be corrected.
What is top-heavy testing?
Top-heavy testing, while technically not a nondiscrimination test, may result in required contributions to participants. It is used to measure whether Key employees (business owners who may have a significant ownership stake in the company or certain officers of the company) own over 60% of the plan assets. A key employee is an individual who:
Owns over 5% of the plan sponsor or a related employer
Owns over 1% of the plan sponsor or a related employer and has an annual employee salary over $155,000 (not indexed)
An officer of the plan sponsor or a related employer with annual compensation above $220,000 (indexed)
Performing top-heavy testing involves comparing the account balances of Key employees to non-Key employees at the end of the plan year. Certain adjustments are made based on distributions paid out in the past five plan years, certain terminated participants are excluded, and all unrelated rollover balances are excluded before this ratio can be calculated.
How is the top-heavy testing ratio calculated?
To illustrate an example of calculating top-heavy testing, let’s assume a company has five employees. Two employees are Key employees, and three are non-Key employees. At the end of the plan year, the account balances for each employee are as follows:
| Employee | Account balance at the end of the year |
|---|---|
| John (key employee) | $200,000 |
| Debbie (key employee) | $150,000 |
| Ryan | $50,000 |
| Sandra | $40,000 |
| Theresa | $40,000 |
For simplicity, none of the account balances contain a rollover source, and everyone is active. To calculate if the plan is top-heavy, we must first sum the account balances for the key employees (John and Debbie), which equals $350,000. We then sum the account balances of all employees, which equals $480,000.
The total account balances of the key employees ($350,000) is then divided by the total account balance of the total assets ($480,000), giving us 73%, which is greater than 60%. Therefore, it is considered a top-heavy plan.
What happens if my plan is top-heavy?
If your plan is top-heavy, the plan sponsor must make corrections by contributing a minimum contribution to non-key employees. The contribution must be the lesser of the highest HCE benefit (including deferrals) for the year, or 3% of compensation. Note, the top-heavy minimum can be met using any employer contribution made during the year.
Corrective contributions must be made by the end of the plan year following the year in which the contributions are due, although the deadline to receive a deduction on an annual corporate return may be sooner. If corrective employer contributions are not made on time, an operational failure has occurred. The plan may make corrections under the Self Correction Program or the Voluntary Correction Program or could be in jeopardy of the plan losing its qualified status.
When is my plan considered to be top-heavy?
Top-heavy testing determinations are made at the end of the PRIOR year, so you will always know ahead of time* if your plan is top-heavy or not. For example, if your plan is considered top-heavy on December 31, 2022, your 2023 plan year will be considered top-heavy, and the top-heavy minimum contribution (see below) will be required to be funded for 2023 no later than December 31, 2024. Plan sponsors should carefully review their compliance testing package for the year to determine if a minimum contribution will be due in the following year, so they can properly plan for the required contribution.
*Note: There is an exception to the “knowing ahead” rule. The first year of a plan may be top-heavy based on the result of the first top-heavy test. As an example, if your first plan year ends on December 31, 2021, and the plan is determined to be top-heavy, both the 2021 and 2022 plan years will be considered top-heavy. The first plan year is the only year that the top-heavy test is used twice.
Can plans be exempt from top-heavy testing?
401(k) plans with a safe harbor provision that only receives elective deferrals and safe harbor minimum contributions are exempt from top-heavy testing. Safe harbor plans also allow employees to max out their contributions without refund concerns. To qualify for this exemption, the plan must meet one of the following requirements:
Providing matching contributions up to 4%
Providing non-elective contributions of 3% of salary for every account, regardless of whether an employee makes a salary deferral
Making contributions under a qualified auto-enrollment plan up to a 3.5% match or 3% non-elective
A safe harbor non-elective provision may be added to a plan retroactively. If you find that your plan is top-heavy, you may want to consider adding the non-elective provision to allow you to bypass the top-heavy test. While you will still be required to fund the 3% minimum contribution, you will receive additional benefits of a safe harbor plan, including bypassing the ADP and ACP tests.
Stay top-heavy testing compliant with Human Interest
Top-heavy testing is an important consideration for businesses that have many high-earning employees and for small businesses that may have a tougher time passing nondiscrimination tests. By understanding the regulations around top-heavy testing, businesses can avoid unplanned employer contributions. Human Interest can help your business uncover which plan design is best for your needs and plausible testing scenarios.
At Human Interest, we guide you along the 401(k) setup process. We can help your business avoid any nondiscrimination testing issues—so you can focus on running your business.
