Retirement Meditation #40: What does it mean that my retirement plan is Top Heavy?

Insights | Retirement Meditation #40: What does it mean that my retirement plan is Top Heavy?

Author: Paul A. Carl, CHSA, CPFA Vice President, Retirement Plan Consulting, Registered Representative

A successful HVAC company sponsored a 401(k) plan. They matched 50% the first 6% of an employee’s deferral contributions; thus, a 6% of compensation deferral resulted in an additional 3% from employer match. The match vested over a 5-year period at 20% per year. Despite semi-annual education efforts, more than half of the company’s 60 employees did not participate. Many who did participate deferred less than 6% and did not attain the maximum match. Three months before year-end, the plan’s advisor reviewed the previous year’s compliance testing results, ran some projections, and determined that the plan would most likely be top heavy for the upcoming plan year. The advisor discussed different options available to the HVAC company. The employer terminated the 401(k) plan at year-end and created a SIMPLE.

A retirement plan becomes Top Heavy when the benefits attributable to the Key Employees are 60% or more of the total benefits available to all plan participants. Vesting does not matter. While Top Heavy status is a rarity, it can lead to a variety of complications especially for the employer and the Key Employees.

The IRS defines a Key Employee as officers or owners of a business who meet certain compensation and/or ownership criteria at any time during the year before the testing date. Specifically, owners making over an IRS-defined amount ($215,000 for 2023) adjusted annually for inflation, business owners holding more than 5% of the stock of the employer, or owners earning more than $150,000 (not adjusted for inflation) and holding more than 1% of the stock of the employer. Everyone not meeting the criteria is a non-key employee. 

Key employees are not always the same individuals as the IRS-defined Highly Compensated Employees. While in some, maybe most situations, the key employee also is a highly compensated employee, it's important to emphasize that the definitions are different.

Non-discrimination testing (ADP and ACP) compares the average deferral rates and average employer matching contribution rates of highly compensated employees to non-highly compensated employees. If one or both tests fail, most often some portion of one or more highly compensated employees’ contributions (and related earnings) are removed from their account. Just the opposite is true for a top heavy plan. For plans that are determined to be top heavy, an employer becomes obligated to make a top heavy contribution up to 3% of compensation. Who receives that top heavy contribution? The governing plan document outlines if the top heavy contribution is made to non-key employees only or to both key and non-key employees.

Is your plan close to top heavy status?

The content of this blog is offered by HORAN Wealth Management, an SEC registered investment advisor. This information is not intended to serve as legal advice or as a substitute for the advice of your own counsel and should not be relied upon as such, as the advice appropriate for you will be dependent upon the particular facts and circumstances of your situation. Linked Websites: We provide links to other sites that we believe may be useful or informative. We do not take responsibility for links to third-party content or the accuracy of the content itself. Any links to third-party sites, or information therein, are not intended as and should not be interpreted by you as constituting or implying our endorsement, sponsorship, or recommendation of the third-party information, products, or services found there. Please note: clicking on external links means you will be leaving this Website; you assume total responsibility and risk for your use of the site(s) you are visiting. Neither the information nor any opinion expressed constitutes a solicitation to use our services or to purchase or sale of any security. Any reference to past performance is not to be implied or construed as a guarantee of future results. Market conditions can vary widely over time and there is always the potential of losing money when investing in securities. HORAN and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only and is not intended to provide and should not be relied on for tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.