What is the 401(k) Top-Heavy Test?

Do your higher-paid employees hold the majority of the funds in your company 401(k) plan? If so, your plan may be top heavy. This occurs when highly paid employees own more than 60% of plan assets. To determine if your plan is top-heavy, the IRS requires some companies to submit to a top-heavy test.

What is a top-heavy test?

Every year, the IRS tests employer-sponsored 401(k) plans to ensure that key employees don’t hold more than 60% of plan assets as of the last day of the prior plan year. If they do, the plan is determined to be top-heavy, and plan administrators must make a minimum contribution of 3% compensation to non-key employees. This compensation is subject to a three-year cliff or six-year graded 100% vesting schedule.

What is the difference between key employees and highly compensated employees?

Key employees are:

• Officers earning over $215,000 annually for 2023
• Business owners holding more than 5% stock
• Owners earning more than $150,000 annually and holding more than 1% of stock

The determination of who is a key employee is based on the year before your testing date. Key employees are not to be confused with highly compensated employees (those who earn more than $150,000 annually). Highly compensated employees count towards ADP and ACP tests but not the top-heavy test.

What is a top-heavy ratio?

The top-heavy ratio is calculated by dividing the total value of key employee accounts by the total value of non-key employee accounts. The final amount is your plan’s top-heavy ratio; if it’s more than 60%, your plan will be considered top-heavy.

Can certain employees be excluded from top-heavy testing?

During the top-heavy testing process, there are a few employee balances that you can exclude:

• A former employee who worked less than an hour: Terminated employees who have maintained their balance in the plan or rolled over their 401(k) to a new employer are examples of this.
• A former key employee: This type of employee used to be considered a key employee but no longer meets the requirement at the time of testing

How can you prevent your plan from becoming top-heavy?

It’s possible for small businesses to become top-heavy after scaling up and hiring additional employees. To help compliance issues with your company’s 401(k) plan, be sure to review the rules and regulations in your plan document. In addition to carefully reviewing your plan document, be sure to complete annual compliance testing.

Employers may also consider switching to a safe harbor 401(k) plan. These plans are often not subject to annual nondiscrimination testing, including the top-heavy test.

ePlan Services simplifies 401(k) compliance by preparing annual compliance tests, including the top-heavy test, for our clients following their annual plan reviews. For further information about compliance testing, visit our Help Center.

This content is for educational purposes only, is not intended to provide specific legal or financial advice, and should not be used as a substitute for the legal advice of a qualified attorney or financial professional. The information may not reflect the most current legal developments, may be changed without notice and is not guaranteed to be complete, correct, or up-to-date.