With the availability of defined-benefit pension plans diminishing as benefit offerings and the future of Social Security remain uncertain, 401(k) plans have evolved into a very popular benefit for employees to use for retirement savings. In addition, company owners and administrators have used 401(k) plans as strategic planning tools to aid in recruiting and retaining key employees.
While 401(k) plans offer tremendous advantages to employees and plan sponsors, they must also comply with several annual IRS testing requirements. One of those annual testing requirements is a top-heavy test.
Smart Business spoke to Phil Scott, Investment Advisor Representative with Sequent Retirement & Benefits Group, about the consequences of a top-heavy 401(k) plan.
When does a 401(k) reach top-heavy status?
A 401(k) reaches top-heavy status when more than 60 percent of the plan’s assets are attributable to key employees. In determining the 60 percent ratio for any plan year, the calculation is made as of the last day of the immediate preceding plan year. Key employees are best defined within 416 of the Internal Revenue Code, but here is a simple checklist that will help determine whether or not an individual is a key employee:
- Officers of the company earning greater than $160,000 annually
- Any employee who owns more than 5 percent of the company.
- Any employee who owns more than 1 percent of the company and earns more than $150,000 annually
What are the implications or penalties when a 401(k) plan falls into top-heavy status?
The plan must meet special minimum contribution and vesting requirements for non-key employees each year that the plan is deemed top heavy. The minimum contribution required to bring the plan back to compliance is the lesser of:
- 3 percent of annual compensation for all non-key employees; or
- A percentage equal to the highest percentage contribution of any key employee
Due to several factors, some plan sponsors may be concerned their 401(k) plans are currently headed into top-heavy status. The economic recession and financial meltdown of 2007-2008 forced many companies to cut salaries, downsize staffing and reduce or eliminate company matching contributions to their 401(k) plans. In reaction to these factors, some 401(k) participants have reduced or even stopped their contributions. Other participants have been forced to take financial hardships or full distributions as a result of job losses. When combining these factors with a plan whose key employees have maintained their contribution levels and seen their account balances improve as a result of the market’s recovery, it is a scenario that may cause the 60 percent top-heavy ratio to be compromised.
How can plan sponsors protect themselves against this top-heavy threat?
Plan sponsors can protect themselves against this top-heavy threat by adopting a Safe Harbor 401(k) plan, which is a specific type of 401(k) plan that encourages non-key and key-employee participation. Safe Harbor plans provide plan sponsors more leniency in setting up their plans, without concerns of becoming top heavy. The Small Business Job Protection Act of 1996 provided for this new type of 401(k) plan, which carries four mandated conditions to maintain its Safe Harbor status:
- Required annual contributions from the company
- 100 percent immediate vesting attached to the required annual company contributions
- Required annual Safe Harbor notification distributed to all eligible plan participants
- Withdrawal restrictions
By following these Safe Harbor guidelines, plan sponsors are permitted to allow their 401(k) plans to become top heavy with no restrictions or penalties.
Securities & Advisory services offered through National Planning Corporation (NPC), Member FINRA / SIPC, a Registered Investment Adviser. Sequent Retirement and Benefits Group and NPC are separate and unrelated companies.
Phil Scott is an Investment Adviser Representative with the National Association of Securities Dealers and a licensed Life & Health Insurance Representative, with 20 years of financial services experience. Reach him at (888) 456-3627 or [email protected]
Sequent is an outsourcing and consulting firm that helps clients improve business performance through HR support, payroll/HR technology and benefits consulting. Sequent also has a safety/risk group and a consulting function that specializes in learning strategies, change management and leadership development.