Nondiscrimination Testing: Top Heavy Determination
The top heavy determination is one of the nondiscrimination tests required by the IRS to ensure plans do not disproportionately favor certain owners and officers.
What is the top heavy determination?
The determination compares the account balances of key employees (defined below) to those of non-key employees. If the sum of all key employee balances exceeds 60% of the total balances in the entire plan as of the determination date, the plan is top heavy, potentially requiring the plan sponsor to make a minimum contribution for each non-key employee.
Who are key employees?
Generally, key employees are the owners and officers of the plan sponsor. More specifically, a key employee is anyone, who at any time during the plan year, fits into at least one of the following categories:
- An individual who owns more than 5% of the plan sponsor or a related employer
- An individual who owns more than 1% of the plan sponsor or a related employer AND has annual compensation exceeding $150,000
- An officer of the plan sponsor or a related employer with annual compensation exceeding $170,000 (indexed for future years)
There are a couple of additional points to note. For purposes of ownership, family attribution rules apply. That means that an individual is generally deemed to own company stock owned by his or her spouse and lineal ascendants/descendants.
For purposes of officer status, no more than 10% of the total employees can be considered officers.
A more detailed description of the definition of key employee is available here.
When is the top heavy determination made?
Unlike other nondiscrimination tests that look backwards to determine compliance, the top heavy determination is forward-looking. At the end of each plan year, the top heavy determination is made to establish whether or not the plan is top heavy for the coming plan year. For example, consider a plan that operated on the calendar year. As of December 31, 2013, it is determined whether that plan is top heavy for 2014. This allows plan sponsors to know in advance whether or not their plans will be top heavy and take any appropriate action steps rather than finding out after the fact.
The last day of the first plan year of the plan's existence is the determination date for both the first and second years.
How is the top heavy determination calculated?
The calculation starts by dividing the participants into key employees and non-key employees and taking the sum of their respective account balances as of the determination date. From there, the following adjustments are made:
- Subtract all unrelated rollovers (those that came from another plan or IRS not related to the plan being reviewed)
- Add back termination distributions that were paid during the twelve-month period ending on the determination date
- Add back all in-service distributions paid during the five-year period ending on the determination date
- Subtract all amounts related to participants who have not performed at least one hour of service for the company during the one-year period ending on the determination date
- Subtract all amounts related to participants who used to be but are no longer key employees
The sum of the key employee balances (after the above adjustments) is divided by the total plan balance (again, after the above adjustments). If the ratio is greater than 60%, the plan is top heavy for the coming year.
The top heavy determination is typically made on a cash basis; however, for the first year a plan is in existence, the accrual method is used.
Who is entitled to receive the top heavy minimum contribution?
IRS guidelines require the contribution to be made on behalf of all non-key employees who are eligible to participate in the plan and remain employed on the last day of the plan year. The plan cannot impose a requirement that a participant work a minimum number of hours to share in the top heavy minimum contribution. Note that an employee who is eligible to make 401(k) contributions must share in the top heavy minimum contribution even if he or she chooses not to make deferrals or is otherwise not yet eligible to share in company contributions.
Plans are permitted to provide the top heavy minimum contribution to key employees also. Be sure to check you plan document to determine what your particular plan requires.
How much is the sponsor of a top heavy plan required to contribute?
The top heavy minimum contribution is based on the amounts contributed by key employees. Specifically, the top heavy minimum contribution is the lower of:
- 3% of compensation, or
- The highest percentage contributed to or for any key employee.
That means that if any key employee defers or receives company contributions of more than 3% of pay, the top heavy minimum contribution is equal to 3%. If, however, all key employees are below 3%, the required contribution is equal to the highest percentage received by any of the keys. If no key employees receive any contributions, the top heavy minimum contribution is 0%.
There are two additional points to note. First, a participant's full year compensation is used to calculate the top heavy contribution even if he or she was a participant for only part of the year. Second, the top heavy minimum contribution is offset dollar-for-dollar by any other company contributions that have already been made, including matching and profit sharing contributions.
When must the top heavy contribution be deposited?
In order to satisfy the top heavy rules, the contribution must be deposited no later than the last day of the year following the year for which it is required; however, in order to deduct the contribution, it must be deposited by the due date of the tax return for the year for which it will be deducted.
Is there any type of top heavy safe harbor?
Generally, safe harbor 401(k) plans are deemed to satisfy the top heavy requirements. To qualify for the free pass, contributions must be limited to only salary deferrals and safe harbor contributions. If there are additional employer contributions, the plan is subject to the regular requirements described above.