What is Top Heavy?
A retirement plan is top heavy if more than 60% of the plan’s assets are attributable to Key Employees. In determining this ratio for any plan year, the calculation is made as of the last day of the immediately preceding plan year.
Who are Key Employees?
Key Employees are defined in §416 of the Internal Revenue Code. In summary, the employees who meet the following criteria in the current year are usually Key Employees:
Officers earning more than $180,000 (indexed through 2019)
Any employee owning more than 5% of the company
Any employee owning more than 1% and earning over $150,000 annually (not indexed)
Note that when determining an employee’s ownership interest in the Company, the Internal Revenue Code generally considers all stock owned by the employee AND his or her spouse, parents, children or grandchildren. This means that children working in a business owned by one or both of their parents are considered Key Employees, even if they own no stock directly. This is referred to as stock attribution.
What happens if my plan is Top Heavy?
If a plan is top heavy, it must meet special minimum contribution and vesting requirements:
Contributions: A top-heavy plan must satisfy minimum contribution requirements for non-Key Employees each year. For a defined contribution plan (such as a 401(k) plan) the minimum contribution is the lesser of:
In most cases, this means if a Key Employee participates, the Company must be prepared to make a 3% minimum contribution each year on behalf of all non-Key Employees who are eligible to participate, regardless of their election to make salary deferral contributions. This minimum contribution is over and above any employee 401(k) salary deferrals. Matching contributions will be counted towards the 3% minimum contribution for the plan years starting in 2002.
It is important that Paragon is aware of all our clients' retirement plans where we may not be engaged to perform service. We have the ability to aggregate testing of other plans or coordinate services with another plan’s providers to ensure that the proper testing is performed, and if applicable, corrections are calculated. Failure to make timely Top Heavy contributions could likely result in the plan being disqualified. Plan disqualification would have significant consequences to both plan participants and the Plan Sponsor.
The 3% minimum contribution can be avoided if no contributions are made on behalf of Key Employees, and there is no ongoing defined benefit pension plan.
If the top-heavy minimum contribution will be made, it can serve as “dual purpose.” It will satisfy the top-heavy rules, and it may also be considered a Qualified Non-Elective Contribution (QNEC) or “fail-safe” contribution to help the plan pass its ADP test. Alternatively, it can serve a dual purpose by providing a base contribution to all employees in a profit sharing contribution allocation. The plan document will determine whether the Key Employees may also receive a 3% contribution.