As a small business owner or HR manager, understanding the 401(k) top-heavy test is crucial for ensuring your retirement plan remains compliant and avoiding unnecessary penalties and fines.
In this blog post, we'll discuss:
Penalties for failing the top-heavy 401(k) test
Strategies to avoid being top-heavy
How to automatically pass the top-heavy test
A top-heavy 401(k) plan is one in which more than 60% of the plan's assets are owned by key employees. This top-heavy ratio is tested every year based on the account balances on the last day of the prior plan year, which is known as the determination date. The IRS conducts top-heavy testing to ensure that these plans do not disproportionately benefit high-ranking employees at the expense of other employees.
In 2023, a key employee is defined by the IRS as an employee who meets one of the following criteria:
Family-owned businesses often have more difficulty with 401(k) top-heavy tests due to the family aggregation rules. Essentially, any spouse, child, grandparent, or parent of a 5% owner is treated as a key employee. Importantly, family members are treated as a single group when calculating ownership – even if no single family member owns 5%, they are all key employees if they own 5% in aggregate.
A non-key employee is everyone else.
If a plan fails the top-heavy test, it must meet certain minimum contribution and vesting requirements to avoid tax penalties.
The top-heavy test is calculated by comparing the total value of key employee balances to the total value of all employees' account balances. If the ratio exceeds 60%, the plan is considered top-heavy and must meet additional requirements to maintain its tax-qualified status.
If a plan fails the top-heavy test, it must meet certain minimum contribution and vesting requirements to avoid tax penalties. Employers may have to contribute up to 3% of each non-key employee's salary to their account or match key employee contributions up to 5% of their salary, whichever is less. Unlike the ADP and ACP tests, you cannot simply return funds to key employees – you have to make contributions.
If you were not planning on contributing to the 401(k), having an unexpected 3% increase in payroll expenses can be challenging for many small businesses.
Smaller businesses and those with a significant portion of assets concentrated among key employees are more susceptible to failing the top-heavy test. Family-owned businesses, start-ups with substantial equity given to founders and early employees, and companies with a few highly paid executives are particularly at risk.
The financial penalties for failing the top-heavy test can be significant for both employers and employees. Let's examine a few numerical examples to better understand the potential costs involved:
Example 1: $45k of unexpected contributions and penalties
Imagine a small business with 10 employees with a total of $1,000,000 in its 401(k) plan. The key employees hold $700,000 (70%) of the plan assets, making the plan top-heavy. The company did not make the required minimum contributions for non-key employees, which amounts to $30,000 (3% of their combined salaries). In this case, the company would face a penalty of $15,000 (50% of the missed contributions) on top of the minimum contribution of $30,000 for failing the top-heavy test.
Example 2: $150k of unexpected contributions and penalties
A larger company has a total of $5,000,000 in its 401(k) plan, with key employees holding $3,200,000 (64%) of the assets. Here, the required minimum contributions for non-key employees amount to $100,000, but the company failed to make those contributions. As a result, the company could face a penalty of $50,000 (50% of the missed contributions) on top of the $100,000 in minimum contributions.
In both examples, the companies may also be subject to additional penalties, such as plan disqualification or excise taxes, which could further increase the financial burden.
There are several strategies that employers can implement to reduce the risk of their 401(k) plan failing the top-heavy test:
There are three common retirement plan types that can help employers avoid failing the 401(k) top-heavy test – however, they all require employers to make a retirement plan contribution, which can be expensive for many small businesses.
Under the right conditions, Safe Harbor 401(k) plans automatically pass top-heavy tests, providing small businesses with a streamlined, compliant retirement plan option.
Safe Harbor 401(k) plans are exempt from top-heavy testing if they meet specific contribution and vesting requirements set by the IRS. These plans are designed to provide more equitable benefits for all employees, regardless of their position within the company.
Safe Harbor 401(k) plans are a popular choice for small business owners and HR managers looking to simplify compliance and ensure equitable benefits for all employees. In fact, in Vanguard's 2022 report, more than 70% of small business plans were Safe Harbor.
These plans offer two primary contribution options: the Safe Harbor match and the non-elective contribution. With the Safe Harbor match, employers match their employee's contributions up to a specified percentage, typically 100% of the first 3% of salary deferrals and 50% of the next 2% of salary deferrals. On the other hand, the non-elective contribution option involves employers providing a flat percentage (usually 3%) of each employee's salary, regardless of whether the employee contributes to the plan.
By implementing one of these contribution structures and meeting specific vesting requirements, Safe Harbor 401(k) plans automatically pass top-heavy tests, providing small businesses with a streamlined, compliant retirement plan option.
A SIMPLE 401(k) plan can be an effective strategy for avoiding the top-heavy test, particularly for small businesses with 100 or fewer employees.
Another strategy for avoiding the 401(k) top-heavy test is implementing a SIMPLE (Savings Incentive Match Plan for Employees) 401(k) plan. This type of plan is designed specifically for small businesses with 100 or fewer employees. Let's take a look at the pros and cons of choosing a SIMPLE 401(k) as a strategy for avoiding the top-heavy test.
In summary, a SIMPLE 401(k) plan can be an effective strategy for avoiding the top-heavy test, particularly for small businesses with 100 or fewer employees. However, it's essential to weigh the pros and cons to determine if this type of plan is the best fit for your business and your employees' needs.
A QACA plan can be a useful strategy for avoiding the top-heavy test by encouraging employee participation and promoting long-term retirement savings.
A QACA is an automatic enrollment feature that can be added to a 401(k) plan, increasing employee engagement and potentially reducing the risk of being top-heavy. QACA plans must meet specific contribution and vesting requirements to be exempt from top-heavy testing. Employers are required to contribute either:
A non-elective contribution of at least 3% of compensation for all eligible non-highly compensated employees
A matching contribution that satisfies the following requirements:
In summary, a QACA plan can be a useful strategy for avoiding the top-heavy test by encouraging employee participation and promoting long-term retirement savings. However, it is important to weigh the pros and cons to determine if this type of plan is the best fit for your business and your employees' needs.
Understanding the 401(k) top-heavy test, its consequences, and the various alternatives available, can help employers maintain a balanced and compliant retirement plan. By leveraging Safe Harbor 401(k) plans, Qualified Automatic Contribution Arrangements (QACA), and other strategies, employers can minimize the risk of facing top-heavy 401(k) consequences while providing equitable benefits to all employees.
ForUsAll offers comprehensive retirement plan solutions that can help employers navigate the complexities of top-heavy testing and create a retirement plan that benefits all employees. Our platform helps monitor top-heavy status throughout the year – preventing surprises at the end of the year. In addition, ForUsAll is particularly skilled at achieving high levels of employee participation, significantly reducing the chance that a plan becomes top-heavy.
We are committed to helping employers navigate these complexities and create a retirement plan tailored to their specific needs. By monitoring top-heavy status throughout the year and emphasizing high levels of employee participation, ForUsAll ensures that your 401(k) plan remains compliant and serves the best interests of your entire workforce. Contact us today to learn more about how our retirement plan solutions can help your business succeed.
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