Top heavy 401(k) plan testing is an annual test required for all 401(k) plan sponsors. The test breaks down plan assets and limits key employees to owning 60 percent or less of all plan assets. Top heavy 401(k) plans that fail testing must be fixed so that all employees benefit from the plan.
Top heavy testing 401(k) plans must be done annually by employer-sponsored 401(k) plans. Human Interest is one 401(k) company that can guide you through this process and make it easier to keep your plan compliant. They can also help you set up a plan that’s exempt from some 401(k) nondiscrimination tests.
How Top Heavy 401(k) Plan Testing Works
Top heavy 401(k) plan testing at the beginning of each plan year is done to measure the percent of plan balances held by key employees and non-key employees. Sponsors of 401(k) plans that fail top heavy testing must make contributions to non-key employees to bring their plan back into compliance before the tax-filing deadline for that year.
A 401(k) plan is top heavy if 60 percent of plan assets are held by participants who meet one of three criteria:
- Company officer making over $175,000
- Person who owns 5 percent or more of the business
- Employee who owns more than 1 percent of the business and makes over $150,000
In order to comply with IRS regulations, top heavy 401(k) plan testing must be conducted annually to make sure that a 401(k) plan is not top heavy. If your 401(k) plan is determined to be top heavy, then you must bring it back into compliance by making contributions to non-key employees.
Consequences for Top Heavy 401(k) Plan Violations
In the event that a plan fails the top heavy test, the plan needs to be brought back into compliance within two years of the violation occurring or face penalties. Depending on the violation, there may be fees or penalties imposed or the plan could end up being disqualified. That’s why it’s so important to take every failed test seriously and work proactively to fix the issues.
401(k) Nondiscrimination Testing: Top Heavy Testing
Top heavy testing only covers those employees who participate in a 401(k) plan. While other types of 401(k) nondiscrimination testing are based on the employee deferrals or contributions, top heavy 401(k) plan testing is calculated based on the plan balance of key employees relative to total plan balance.
How to Fix a Top Heavy 401(k) Plan
If top heavy testing determines that 60 percent or more of your plan assets are held by key employees, you must make employer contributions for all non-key employees equaling or exceeding the highest employer contribution made to a key employee over the past year. This correction must occur before the last day of the year following the violation.
To be exempt from top heavy 401(k) plan testing, you can use a Safe Harbor 401(k). However, using a Safe Harbor plan requires that you meet certain minimum employer matching requirements. For more information on Safe Harbor 401(k) plans and 401(k) nondiscrimination testing, read our ultimate guide to Safe Harbor 401(k) Plans.
One of the best 401(k) companies for 401(k) Safe Harbor plan is Human Interest. Human Interest is a smaller company that leverages technology to offer 401(k)s, including Safe Harbor plans, at very competitive cost. For more information on what Human Interest offers and how they can help structure a plan to benefit your business, be sure to visit their website.
There are three ways to correct a top heavy 401(k) plan:
1. Self-Correction Program
If the violation of top heavy 401(k) plan testing is minor and certain eligibility criteria are met, you may be able to correct your plan using a self-correction program. A self-correction program does not involve guidance or approval from the IRS, and requires making employer contributions for non-key employees to bring the plan into compliance.
According to the IRS, only some plan errors are eligible for self-correction. Under a self-correction program, top heavy 401(k) plans typically need to be corrected within two years of the violation. However, if the errors are insignificant, they may not need to be corrected within two years.
2. Voluntary Correction Program
A Voluntary Correction Program (VCP) is a solution that involves working out a specific correction plan with the IRS. While VCP does involve user fees ranging from $1,500 – $3,500 (depending on plan assets), plan sponsors are more assured of maintaining tax-qualified status for their 401(k) while correcting a top heavy violation.
Under VCP, as with a self-correction program, plan sponsors make contributions for all non-key employees to bring the plan back into compliance. However, plan sponsors also have to pay certain user fees that must be reported to the IRS. VCP is usually better for larger plans, those that have significant violations, or employers who want to ensure they maintain their tax-qualified status.
3. Audit Closing Agreement Plan
If your 401(k) plan is under audit, you’ll be ineligible for a voluntary correction program. Instead, you’ll work with the IRS to structure an agreement outlining your corrective action plan and negotiate a sanction based on factors including the number of employees affected and steps taken by the employer to prevent or correct the error.
Under an Audit Closing Agreement Plan, your specific corrective actions will be negotiated and outlined with the IRS. You will be responsible for following your correction plan document or may risk having your plan disqualified.
Top Heavy 401(k) Plan Examples
Imagine you have a 401(k) plan with four participants (including yourself, the business owner). None of your employees makes over $175,000 and you own 100 percent of the business, so your business has just one key employee—you. Let’s also say that your 401(k) plan matches employee deferrals up to 3 percent.
Each year, you are required to conduct top heavy testing for the 401(k) plan to see whether your plan is in compliance. If you find that 60 percent or more of the total plan balance is held by key employees (just you in this example), then you are required to make contributions for all key employees equal to the matching contributions you gave yourself the previous year.
Top Heavy 401(k) Plan Testing Example & Results
| Percent of Plan Assets Owned by Key Employees | Highest Employer Contribution for a Key Employee | Test Result | Action Required |
|---|---|---|---|
| 40% | 3% | Pass | None |
| 50% | 3% | Pass | None |
| 60% | 3% | Pass | None |
| 70% | 3% | Fail | Contribute 3% to all non-key employees |
| 80% | 3% | Fail | Contribute 3% to all non-key employees |
Plans & Businesses Most Susceptible to Top Heavy 401(k) Plan Violations
Because of the distinctions between key- and non-key employees, there are certain types of businesses that are particularly susceptible to failing top heavy testing. These include companies that have considerable disparity among employee compensation, high numbers of key employees relative to non-key employees, or low plan participation from non-key employees.
Four types of business that are most susceptible to top heavy 401(k) plan violations are:
- Small Businesses Owned by Big Savers – If the founder or owner of a company makes sizeable contributions to their own 401(k) account each year, they may have a top heavy 401(k) plan unless their employees keep up.
- Companies with Low Participation by Non-Key Employees –
- Businesses with Significant Wage Disparity – May include lots of unskilled labor.
- Small Family-Owned Businesses – Lots of family members own 5 percent or more, don’t have non-key employees to offset.
“Small family-owned businesses have a particularly hard time passing this test since in many of these instances, all the family members are considered Key Employees. So in the circumstances where it is a small employer, the family members can make up the majority of the workforce. Since the family members are usually the ones to not leave employment, the family members’ account balances grow faster than those of the other workforce.” – Cindy Bloch, Chief Compliance Officer, ForUsAll
Top Heavy Testing & 401(k) Nondiscrimination Tests
Top heavy testing 401(k) plans is a forward-looking test that plan administrators must run annually in addition to several other types of 401(k) nondiscrimination testing. These include ADP testing and ACP testing, which are backward-looking and compare the deferrals and contributions of highly-compensated employees with those of non-highly compensated employees over the past year.
The two other main types of 401(k) nondiscrimination testing include:
The ADP Test
The Actual Deferral Percentage Test must also be conducted each year, and requires employers to compare the average annual deferral rates of highly-compensated employees (HCEs) and non-highly compensated employees (NHCEs). To compare these rates, you first calculate the Actual Deferral Rate for each employee by dividing each employee’s contributions (both pre-tax and Roth) by their annual compensation.
Once you’ve calculated the actual deferral rate for each employee, you have to find the average deferral rates for HCEs (including any 5 percent owners) and NHCEs. Under the ADP test, the average deferral rate for HCEs can’t exceed certain limits based on the average deferral rate of NHCEs.
The ACP Test
In addition to the ADP test, employers are also required to conduct the ACP test annually. The Annual Contribution Percentage Test is very similar to the AP test except that it includes employer matching in addition to employee salary deferrals and after-tax contributions.
To conduct the ACP Test, employers must calculate each employee’s annual contribution rate by adding employee deferrals, after-tax contributions, and employer matching and then dividing the total by each employee’s total annual compensation. Employee rates are than averaged for HCEs and NHCEs, with HCE contributions limited relative to the average NHCE contribution rate.
ADP/ACP Testing Compliance Limits
| NHCE Average Annual Deferral/Contribution Rate | Maximum HCE Average Annual Deferral/Contribution Rate |
|---|---|
| 0% – 2% | 2x NHCE rate |
| 2% – 8% | NHCE rate + 2% |
| 8%+ | 1.25x NHCE rate |
In addition to top heavy testing 401(k) plans, both the ADP test and ACP test must be conducted annually for every plan (though they’re typically conducted by 401(k) companies as part of plan administration). These 401(k) nondiscrimination tests have ranges that define plan compliance and require corrective actions by plan sponsors for those plans that are not compliant.
Top Heavy 401(k) Plan Testing vs ACP/ADP Test
Each year, 401(k) plan sponsors must conduct 401(k) nondiscrimination testing, including top heavy testing for 401(k)s. Unlike ADP and ACP testing, top heavy testing is not for the previous year but for the next year. If you fail top heavy testing, you’re required to make corrective contributions for the succeeding year.
In addition to different timing, the calculations for top heavy 401(k) plan testing is also much simpler, including:
- Total plan balances for each employee
- Divide total plan balances for key employees by total plan balance
- If key employee balance exceeds 60 percent of total plan balance, make corrective contributions
If your business may have trouble passing top heavy 401(k) plan testing, consider using a 401(k) Safe Harbor plan, which is exempt from 401(k) nondiscrimination testing such as top heavy testing. Human Interest is a great provider of Safe Harbor 401(k) plans, but if you decide to use a Traditional 401(k) plan, they can alert you before your plan becomes non-compliant.
Top Heavy 401(k) Plan Frequently Asked Questions (FAQs)
Below you’ll find the most commonly asked questions regarding top heavy 401(k) plans. If after reading our article you still have questions that aren’t listed here, please post it in our forum and we’ll be happy to have a discussion to clarify or answer anything you may be wondering about regarding how top heavy testing works.
What Is a Safe Harbor 401(k) Plan?
A 401(k) Safe Harbor is a 401(k) plan that is exempt from top heavy 401(k) plan testing and other 401(k) nondiscrimination testing. However, Safe Harbor 401(k) plans are still required to perform top heavy 401(k) plan testing if they have a profit-sharing component.
What Is the Highly-Compensated Employee (HCE) Limit?
To qualify as a highly-compensated employee for 401(k) nondiscrimination testing, an employee must earn more than $120,000 in cash and stock compensation for the year. Also included as a highly-compensated employee is anyone who owns more than 5 percent of the company or did so in the previous year.
Is Profit-Sharing Included in 401(k) Nondiscrimination Testing?
Profit-sharing is only included in some 401(k) nondiscrimination tests. For example, profit-sharing is included in Top Heavy 401(k) plan testing but is excluded from the Actual Deferral Percentage (ADP) Test. Profit-sharing can also be deemed to automatically pass nondiscrimination testing depending on how an employer distributes profit-sharing contributions.
When an employer makes discretionary profit-sharing contributions to a 401(k) plan, those contributions are divided among plan participants according to a preselected formula. If an employer divides contributions pro rata based on employee compensation or using a formula called “permitted disparity” (which gives HCEs a slightly higher portion of profit-sharing), then profit-sharing may automatically pass nondiscrimination tests.
If, however, profit-sharing is weighted more heavily for HCEs, these contributions may have to undergo additional, more complicated nondiscrimination testing.
Bottom Line
Top heavy 401(k) plan testing is a test that plan sponsors must conduct annually. Unlike other nondiscrimination tests, top heavy testing is based on participant balances rather than employee deferrals or contributions. If you have a top heavy 401(k) plan, you can use employer contributions for non-key employees to make your plan compliant.
If you would like to set up a plan that is exempt from top heavy 401(k) plan testing or would like advance warning if your plan is headed toward noncompliance, we recommend working with Human Interest. Human Interest is a relatively new company that has made 401(k) nondiscrimination testing much more seamless and helped employers set up plans that are exempt from this testing.
