Top-Heavy Plan Testing

Top-heavy plan testing is a crucial compliance check that employers must perform each year on qualified retirement plans, such as 401(k)s and profit-sharing plans. The purpose is to verify that benefits do not disproportionately favor key employees—typically company owners, officers, or highly compensated individuals—over the rest of the workforce. This testing helps maintain the fairness and non-discriminatory nature of retirement plans as required by IRS regulations.

Why Top-Heavy Plan Testing Exists

Congress introduced top-heavy rules to prevent retirement plans from disproportionately benefiting business owners and executives while providing minimal benefits to rank-and-file employees. Without these safeguards, employers might design plans favoring themselves, undermining the goal of broad-based employee retirement security.

Defining Key Employees

To perform top-heavy testing, plans identify “key employees,” who commonly include:

• Officers earning above the IRS compensation threshold ($200,000 for 2023)
• Owners with more than 5% ownership interest
• Owners with more than 1% ownership who also earn over $150,000 annually

These classifications ensure that highly compensated individuals are subject to scrutiny in asset concentration analysis.

How the Test Works

The plan fiduciary calculates each participant’s account balance or accrued benefits to ascertain what percentage of total plan assets key employees hold. If this percentage exceeds 60%, the plan is deemed “top-heavy.” Employers then must provide minimum contributions to non-key employees to restore balance.

Corrective Actions Required

If a plan is top-heavy, employers typically must contribute at least 3% of compensation for each non-key employee or match the percentage of key employees’ contributions if lower than 3%. This ensures that non-key employees receive a minimum level of benefits.

Implications for Employers and Employees

• Employers: Must perform annual top-heavy testing to avoid IRS penalties and maintain tax-qualified status of the plan.
• Key Employees: Their benefits are closely monitored since they heavily influence the plan’s top-heavy status.
• Non-Key Employees: They are protected by minimum contribution rules to ensure fair participation.

Managing Top-Heavy Risks

Employers can reduce the likelihood of top-heavy status by:

• Offering profit-sharing contributions to non-key employees.
• Structuring vesting schedules thoughtfully.
• Utilizing safe harbor plan features.
• Engaging third-party administrators for accurate compliance testing.

Common Misconceptions

• Size Exemption: Even small plans must perform top-heavy testing annually.
• Plan Closure: A top-heavy result does not require plan termination but does necessitate corrective contributions.
• Who Are Key Employees: Key employees include both owners and high-ranking officers, not just owners.

Frequently Asked Questions

When is top-heavy testing performed? Testing is conducted annually, usually shortly after the plan year ends, but no later than 12 months afterward.

Can some employees be excluded? Certain categories, such as union employees covered by collective bargaining or those with less than one year of service, may be excluded based on plan terms.

What if rules are not followed? Failure to comply can lead to plan disqualification, loss of tax advantages, and IRS penalties.

Which plans are subject? Most qualified defined contribution and defined benefit plans undergo this test; IRAs and non-qualified plans are excluded.

Summary Table: Top-Heavy Plan Testing

Understanding top-heavy plan testing helps employers maintain fair and compliant retirement benefits for all employees. Regular testing, careful plan design, and timely corrective contributions are essential to avoid penalties and support workforce financial security.

For detailed official guidance, visit the IRS page on Top-Heavy Plans.