Top heavy plan

What Is a Top Heavy Plan?

A top heavy plan is a type of qualified retirement plan, such as a 401(k) or pension plan, that disproportionately favors a company's owners and most highly paid employees, known as key employees. Specifically, a retirement plan is considered top-heavy if the aggregate value of the plan accounts of key employees exceeds 60% of the total value of the plan assets for all employees on a specified date. This classification falls under the broader category of Retirement Plans and Employee Benefits, specifically governed by U.S. tax law. The designation of a plan as top-heavy triggers specific requirements designed to ensure that lower-paid employees, referred to as non-key employees, still receive a minimum level of benefits.

History and Origin

The concept of a top heavy plan and the regulations surrounding it emerged from the broader efforts to prevent discrimination in employer-sponsored retirement plans. Prior to the Employee Retirement Income Security Act of 1974 (ERISA), some retirement plans heavily favored owners and executives, offering minimal benefits to the rank-and-file workforce. ERISA was enacted to establish minimum standards for most voluntarily established retirement and health plans in private industry, aiming to protect participants and beneficiaries.¹² The non-discrimination rules within ERISA mandate that all eligible employees must be treated fairly regardless of their position or compensation.¹¹

The specific "top-heavy" rules were later introduced under Section 416 of the Internal Revenue Code to bolster these non-discrimination principles, particularly as defined contribution plans like 401(k)s became more prevalent. These rules were designed to ensure that even if a small group of highly compensated individuals accumulated a significant portion of the plan's assets, other employees would still receive at least a minimum contribution and accelerated vesting. This legislative intent aimed to balance the tax advantages offered to employers and participants of qualified plans with the goal of providing broad-based retirement security.

Key Takeaways

• A top heavy plan is a retirement plan where more than 60% of the aggregate account balances are held by key employees.
• The determination date for top-heavy status is typically the last day of the preceding plan year.¹⁰
• If a plan is deemed top-heavy, the employer must provide a minimum contribution to non-key employees, generally 3% of their compensation.⁹
• Top-heavy plans may also require more rapid vesting schedules for employer contributions.⁸
• These rules are part of the broader non-discrimination rules set forth by the IRS and Department of Labor to ensure fair benefit distribution.

Formula and Calculation

The determination of whether a plan is top-heavy involves a direct calculation of the ratio of key employee account balances to the total plan assets.

The formula for the top-heavy ratio is:

If this ratio exceeds 60% as of the determination date (typically the last day of the prior plan year), the plan is considered top-heavy for the current plan year.⁷

Variables:

• Aggregate Account Balances of Key Employees: The sum of all account balances for individuals classified as key employees under the plan.
• Total Aggregate Account Balances of All Employees: The sum of all account balances for all participants in the plan, including both key and non-key employees. This includes tax-deferred contributions, employer matching contributions, and any other employer contributions.

Interpreting the Top Heavy Plan

Identifying a top heavy plan is a critical step in retirement plan administration, particularly for small and closely held businesses where ownership and highly compensated individuals often comprise a significant portion of the workforce. If the calculated top-heavy ratio exceeds 60%, the plan must implement certain minimum benefit requirements for non-key employees. This ensures that the plan maintains its qualified plan status with the IRS, allowing continued tax advantages for both the employer and participants. Failure to satisfy these requirements can lead to plan disqualification.⁶ The determination is performed annually, meaning a plan's status can change from year to year based on contributions, withdrawals, investment performance, and employee demographics.

Hypothetical Example

Consider "Alpha Tech Solutions," a small software company with a 401(k) profit-sharing plan. On December 31, 2024 (the determination date for the 2025 plan year), the total assets in their 401(k) plan are $1,000,000.

Let's identify the key employees and their account balances:

• CEO (Key Employee): $400,000
• CTO (Key Employee): $250,000
• Head of Sales (Key Employee): $100,000
• Total Key Employee Balances: $400,000 + $250,000 + $100,000 = $750,000

The total aggregate account balances of all employees (including the non-key employees) is $1,000,000.

Now, calculate the top-heavy ratio:

Since 75% exceeds the 60% threshold, Alpha Tech Solutions' 401(k) plan is considered a top heavy plan for the 2025 plan year. As a result, for 2025, Alpha Tech Solutions must make a minimum contribution to all eligible non-key employees, typically 3% of their compensation, and comply with the accelerated vesting rules.

Practical Applications

The top heavy plan rules are primarily applied in the context of qualified plan compliance, particularly for smaller businesses or those with a high concentration of plan assets among a few individuals. These rules influence several aspects of retirement plan management:

• Plan Design and Contributions: Employers sponsoring a top heavy plan must ensure that non-key employees receive a minimum employer contribution. This can impact the overall cost of maintaining the plan and may influence decisions on whether to offer a defined contribution plan or a defined benefit plan.
• Compliance and Testing: Annual discrimination testing for retirement plans includes the top-heavy test. Plan administrators must accurately identify key employees and calculate the top-heavy ratio each year. The Internal Revenue Service (IRS) provides guidance on how to fix common errors related to top-heavy plans to avoid disqualification.⁵
• Vesting Schedules: If a plan is top-heavy, employer contributions for non-key employees must follow an accelerated vesting schedule, either a three-year cliff vesting or a six-year graded vesting schedule.⁴ This ensures that non-key employees gain rights to employer contributions more quickly.
• Safe Harbor Plans: Certain plan designs, such as a safe harbor 401(k), can automatically satisfy the top-heavy minimum contribution requirements and are generally exempt from top-heavy testing. This offers a way for employers to avoid the complexities of top-heavy rules.

Limitations and Criticisms

While the top heavy plan rules aim to promote fairness in retirement plans, they do present certain limitations and can face criticism:

• Cost Burden for Small Businesses: For small businesses, particularly those with highly compensated founders or a few key employees, meeting the minimum contribution requirements can be a significant financial burden. This can sometimes discourage small employers from offering qualified plans altogether, potentially limiting retirement savings opportunities for all employees.
• Complexity: The identification of a key employee and the annual top-heavy testing can be complex, requiring careful record-keeping and understanding of IRS regulations. Miscalculations or oversight can lead to severe penalties, including plan disqualification.³
• Focus on Asset Distribution, Not Participation: The rules primarily focus on the distribution of plan assets rather than the rate of participation by non-key employees. Even if non-key employees choose not to contribute to a defined contribution plan, the employer may still be required to make a minimum contribution if the plan is top-heavy.
• Limited Applicability to Larger Plans: Larger companies with a broad employee base rarely become top-heavy due to the sheer number of non-key employees whose combined balances typically outweigh those of key employees, making the rules less relevant for them.

Top Heavy Plan vs. Highly Compensated Employee

The terms "top heavy plan" and "highly compensated employee" are closely related concepts in Retirement Plans and employee benefits, but they serve distinct purposes in discrimination testing.

A top heavy plan refers to the entire retirement plan itself. It describes a plan where more than 60% of the aggregate account balances are attributed to "key employees." The definition of a key employee includes officers, 5% owners, and 1% owners with compensation over a certain threshold. The consequence of being a top heavy plan is the requirement to provide minimum contributions and accelerated vesting for non-key employees.

In contrast, a highly compensated employee (HCE) refers to an individual employee who meets specific compensation or ownership criteria established by the IRS. Generally, an HCE is someone who owned more than 5% of the business at any time during the current or preceding year, or had compensation above a certain indexed amount in the preceding year. HCEs are primarily used for other non-discrimination rules, such as the Actual Deferral Percentage (ADP) test and Actual Contribution Percentage (ACP) test, which compare contribution rates between HCEs and non-highly compensated employees (NHCEs).

While there can be overlap (a key employee is often also an HCE), the classifications are distinct, and the rules they trigger serve different aspects of preventing plan discrimination.

FAQs

What happens if a plan becomes top-heavy?

If a plan becomes a top heavy plan, the employer is generally required to make a minimum contribution to eligible non-key employees. This contribution is typically 3% of their annual compensation, or the highest percentage contributed for a key employee, if less than 3%. Additionally, employer contributions must follow an accelerated vesting schedule.²

Can a 401(k) plan avoid being top-heavy?

Yes, certain plan designs can help avoid top-heavy status. The most common method is implementing a "safe harbor" 401(k) plan, which involves specific employer contributions (either matching contributions or non-elective contributions) that automatically satisfy the top-heavy minimum contribution requirements and exempt the plan from top-heavy testing.

Are all retirement plans subject to top-heavy rules?

No. The top-heavy rules primarily apply to qualified plans, such as 401(k)s, profit-sharing plans, and pension plans. Certain types of plans, like Simplified Employee Pension (SEP) IRAs and Savings Incentive Match Plans for Employees (SIMPLE) IRAs, have their own non-discrimination requirements and are generally exempt from top-heavy testing.

How is a "key employee" defined for top-heavy purposes?

For top-heavy purposes, a key employee is an individual who, at any time during the preceding plan year, was: an officer earning more than an inflation-adjusted threshold, a 5% owner of the business, or a 1% owner of the business with annual compensation exceeding $150,000.¹