What Is a Top Heavy Plan and How Does It Affect Your 401(K) Plan?

What does it mean when a plan is top heavy? Can a top heavy plan affect my 401(k)? If you’re asking those questions, you probably heard someone mention top-heavy 401(k) accounts. You’ll be interested in hearing more about them, whether you are an employee or employer. Here’s some helpful information about such plans:

What Does Top-Heavy Mean for 401(k)?

The term top-heavy refers to the percentage of ownership in a plan of assets. A top-heavy situation is one where the key employees in an establishment own more than 60 percent of the plan. The government tests organizations to assess whether their plans are top-heavy. If so, the businesses have to contribute a certain amount of funds to the non-key employees to compensate. 

A key employee is an officer who earns more than $2,000. It can also be a business owner who earns more than 5 percent of the company’s capital. Owners who own more than 1 percent of the business’s stock and earn over $150,000 can also be deemed as key employees. 

How Does Being Top-Heavy Affect My 401(k)?

If you are a non-key employee, you may be entitled to additional compensation from the business. They would be required to contribute an additional 3 percent of compensation for the entire year or the highest percentage for a key employee. Usually, the plan must be brought into compliance within two years, and failure to do so could result in penalties such as fees or plan disqualification.

As an employer or key employee, it’s crucial to avoid having the government find you in a top-heavy situation. You can do that using a few methods mentioned below.  

How To Prevent a Top Heavy Account

To avoid being subjected to the top-heavy rules regarding 401(k) plans, your business can do a few things:

Use a Safe Harbor Contribution Formula

Safe harbor plans include matching contributions of up to 4 percent on accounts that offer elective deferrals. These plans can also offer a 3.5% non-elective employer contribution or 3 percent of the employee’s salary, whether they make salary deferrals or not. Auto-enrollment plans offer a 3.5 percent match or a 3 percent non-elective match. 

Know the Top-Heavy Calculations

Communicating with the IRS and finding out how the calculations work is one way to stay abreast of your top-heavy situation. You can then take steps to bring the numbers down before the calculations get processed at the end of the year. Generally, it’s the value of all of your employees’ accounts divided by their accounts’ value on the last day of the previous year.

Use Voluntary or Self-Correction Plans

You also have an option to use a self-correction plan that might involve having some of your key employees change a few things. The alternative is to get involved with a voluntary correction plan with the IRS that will bring your account into compliance. With that option, you’ll know your actions are correct because the IRS will guide you. 

Now you know a little bit about top-heavy 401(k) accounts. Use the information as an incentive to learn more.