Decreases in the deferral rates of non-owner, non-officer, and lower paid employees plus distributions of account assets to departing employees can create a perfect equation for making some 401(k) plans “top heavy.” Below, we review the top-heavy rules and some steps employers may to take to avoid having their plans become top heavy.

Defined contribution plans, such as 401(k) plans, generally are considered top heavy when the accounts of “key employees” represent more than 60% of the total value of all employee accounts. A plan that tests as top heavy on the last day of the 2009 plan year will be subject to the top-heavy rules for the 2010 plan year.

Key Employees

The difference between “key” employees and other employees is not simply a question of compensation. A key employee is any individual whose role in the company, based on ownership,position, or compensation, fits the law’s key employee definition. For purposes of the top-heavy rules, key employees include:

• Owners of more than 5% of the business,
• Company officers with compensation greater than $160,000 in 2009, and
• Individuals who own more than 1% of the business and earn more than $150,000 a year.

In determining the 1% and 5% ownership, an individual is considered to own stock owned by certain family members.

Top-heavy Rules

Plan documents must include provisions that take effect whenever the plan becomes top heavy. Under the top-heavy rules, the employer sponsoring the plan generally must contribute at least 3% of compensation on behalf of non-key employees. However, there are exceptions. For example, if the highest allocation, including elective deferrals, to any key employee is less than 3%, the sponsor can contribute that lower percentage of compensation to non-key employees’ accounts.

All non-key employees who are plan participants and active employees at the plan’s year-end must receive the minimum contribution regardless of actual hours worked. Not making required minimum top-heavy contributions can jeopardize a plan’s tax-exempt status.

Strategies

If you think your plan could be headed toward being top heavy by year-end, consider whether any of the following strategies could help you stay clear of the 60% threshold.

• Deposit all employer contributions for non-key employees before the end of the plan year and delay employer contributions for key employees until after the end of the plan year. Except for the first plan year, the top-heavy determination is made on a cash basis, so contributions that are accrued but not yet deposited at year-end are not included in the calculation.
• If the plan permits, make additional profit sharing contributions on behalf of a designated group of non-key employees before year-end.
• Look for prior distributions to non-key employees. Distributions made because of termination of employment, death, or disability during the prior 12 months have to be included in the top-heavy calculations. Other in-service distributions, such as hardship distributions or loans in default treated as distributions, must be added back if they occurred during the five-year period ending
  on the testing (“determination”) date.

If you have concerns about your plan failing the top-heavy test, contact us. We can help you assess the danger for this plan year and develop long-term strategies for avoiding top-heavy classification in future years.