401(k) Plan Sponsors need to understand the implications of their Plan being Top Heavy. Slipping into the Top Heavy category can bring a nasty surprise to a client that does not want to be committed to making employer contributions.
For a Plan to be Top Heavy for a given Plan Year the Key Employees have more than 60% of the total account balances as of the last day of the prior Plan Year. I won't go into it here, but the Key Employee definition is not quite the same as the definition of Highly Compensated Employees.
Being a Top Heavy Plan is not problem as long as times are good and the company contributes 3% of pay or more each year as a Profit Sharing contribution. Top Heavy is also not a problem for a client who maintains a Safe Harbor 401(k) Plan. But many companies maintain the 401(k) Plan simply to allow employees to make salary deferrals with no intention of adding company contributions or at some point they decided to stop making company contributions due to a business downturn. Unfortunately if over time the Key Employees take advantage of doing salary deferrals more than the rest of the staff and the percentage of plan assets for Key Employees creeps over the 60% level as of the last day of the year, then the Employer can be in for a very nasty surprise for the next Plan Year.
If a 401(k) Plan is Top Heavy and if ANY of the Key Employees engage in salary deferrals, then the company is going to be faced with making Top Heavy minimum contributions, whether they can afford to or not. Ouch!
If any of the Key Employees have made salary deferrals of 3% of pay or more, then the Top Heavy minimum contribution is 3% of the pay of all of the Non-Key Employees. So, for example, if a small company had a payroll of $1,000,000 for all of the Non-Key employees, the Top Heavy minimum contribution would be $30,000. This is not something the business owner is very happy about finding out when it is too late to do anything about it.
It takes a bit of forward planning to avoid the nasty surprise. First, you have to be aware of whether or not the Key Employees might have more than 60% of the total assets as of the last day of a Plan Year. If it appears likely that the plan will be Top Heavy, to avoid the Top Heavy Minimum, the Plan Sponsor will need to tell all of the Key Employees to cease their salary deferrals as of the first day of the Top Heavy year. They can do salary deferrals later in the year if it is determined that the company will be able to afford a Profit Sharing contribution of 3% of pay or more for everybody.
If the plan is close to being Top Heavy, the Plan Sponsor may want to routinely cease the salary deferrals of all Key Employees at the beginning of each plan year until it is determined by the TPA or record keeping vendor if that year is Top Heavy or not. The business owner will tend to blame everybody for not proactively warning them that this might be an issue.
It would be a good idea if you are the CPA for some clients who sponsor 401(k) Plans to have the client ask the TPA how close they are to being Top Heavy and for those that are close, take the protective action described above. If a client finds out they are Top Heavy already, then they need to gain a full understanding of the implications.
If you know certain clients do have a 401(k) Plan, you might consider sending them an email link to this blog post - just a little service "above and beyond" for them from their proactive CPA.
