A 401k plan is determined to be top heavy if the sum of all key employee account balances exceeds 60% of the total balances in the plan as of the last day of the prior plan year. That means the determination is forward looking and affects the upcoming year. For example, if you have just finished the year 2020, you would calculate if the plan will be considered top heavy for 2021 based on the 2020 year-end balances.
Why does it matter if your plan is top heavy? If your plan is top heavy you may be required to make minimum contributions for each non-key employee at your company’s expense. For the calculation you need to know who in the plan is a key employee. A key employee is an individual who meets any one of the following requirements:
- Owns more than 5% of the company providing the plan or a related employer
- Owns more than 1% of the company or related employer and has annual compensation exceeding $150,000 for the plan year
- An officer of company or related employer with annual compensation exceeding $185,000 for 2020 and 2021
Also, for the purposes of ownership, family aggregation rules apply. Any individual who has a spouse, child, grandparent or parent who owns more than 5% is considered to own more than 5%. If the individual and the relation together own more than 5%, the individual is considered to own more than 5%. This would make them a key employee. It is important to provide the person performing the top-heavy calculation with the family ownership interests of all company stock if your company has stock ownership.
If your plan is determined to be top-heavy you must make a corrective contribution that includes lost earning to the non-key employees. The minimum contribution amount is the lower of 3% of compensation or the highest percentage contributed to or for any key employee. That means if any key employee defers more than 3% of their pay the minimum contribution required is 3%. If all key employees defer less than 3% and the highest deferral received by the key employees is 2% the minimum contribution amount will be 2% of pay. On top of the minimum amount, you will need to calculate the lost earnings and add those to the minimum contribution amount.
If top-heavy plans are not corrected it can cause the plan to become disqualified, causing you and your employees undesirable tax consequences. Timely and accurate calculations are important to help keep your plan from being top-heavy. Another option is to structure the plan so that the top-heavy minimum allocation requirements and vesting schedules are automatically satisfied year after year.
Please contact your Henry+Horne advisor with any questions on your top heavy 401k plan.
Davis Smith, CPA