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When a Plan Is Top Heavy

SITUATION: Our company has to make an additional contribution to our 401(k) plan for nonkey employees because the plan is considered “top heavy.”

QUESTION: How can we avoid having our 401(k) plan classified as top heavy in the future?

ANSWER: Adopting a “safe harbor” plan design is one option you may want to consider. Safe harbor 401(k) plans that meet certain conditions avoid the top-heavy rules and annual nondiscrimination testing.

DISCUSSION: Under the tax law, 401(k) and other defined contribution plans  generally are considered top heavy when the aggregate value of the accounts of “key employees” as of the last day of the preceding plan year represents more than 60% of the aggregate value of all employee accounts.
For purposes of these rules, key employees include:

  • Owners of more than 5% of the business
  • Company officers with compensation greater than $170,000 (for 2015; subject to future inflation adjustment)
  • Individuals who own more than 1% of the business and earn more than $150,000 a year

Ownership by certain family members and entities is considered in determining whether a participant has a 1% or 5% ownership in the business. Any employee who is not a key employee is a nonkey employee.

When a plan becomes top heavy, the employer sponsoring the plan generally must contribute at least 3% of compensation on behalf of each nonkey employee. All nonkey employees who are participants at the end of the plan year (and haven’t separated from service) must receive the minimum contribution. Additionally, the plan must have a minimum vesting schedule. Failure to satisfy these requirements can jeopardize a plan’s tax-qualified status.

As noted, a safe harbor 401(k) plan can automatically satisfy the top-heavy plan rules. With a safe harbor plan, the employer is required to make nonelective employer contributions of at least 3% of compensation or matching contributions under a specified formula (100% of a participant’s deferrals up to 3% of compensation and 50% of deferrals between 3% and 5% of compensation). Only plans that consist solely of elective deferrals and safe harbor employer contributions qualify for the top-heavy exemption.

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