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?
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