The IRS requires several annual nondiscrimination tests for defined contribution retirement plans, and the top-heavy test is one of those. A retirement plan is top-heavy when, as of the last day of the preceding plan year (the determination date), the total value of the plan assets of key employees exceeds 60% of the total value of the plan assets.
A key employee is defined as either:
- A more than 5% owner
- A more than 1% owner with compensation greater than $150,000
- An officer with compensation greater than $200,000 for 2022
As the top-heavy determination is based on retirement plan assets and balances, it is possible to become top-heavy even after a year in which no contributions are made.
IRS top-heavy rules aim to ensure that lower-paid employees are receiving at least a minimum benefit in cases when the majority of retirement plan assets are owned by key employees. If the employer maintains more than one retirement plan, the plans must be combined for top-heavy determination.
What Does It Mean to Be Top-Heavy?
When a retirement plan is top-heavy, employers need to allocate a minimum contribution. This contribution is based on the contributions of key employees; the minimum is the lesser of 3% of total compensation for the entire plan year or the highest percentage of compensation contributed for a Key employee. Typically, the minimum contribution is 3% of compensation.
Employee elective deferrals do not count towards this minimum. All non-key employees who were eligible to participate in the retirement plan (whether they deferred or not) and are employed on the last day of the plan year must receive the top-heavy minimum contribution. A minimum hour requirement cannot be imposed on this contribution.
How to Avoid Top Heavy Minimum
A safe harbor retirement plan may use safe harbor contributions towards satisfying the top-heavy minimum contributions. For example, a 3% nonelective safe harbor will fully satisfy the top-heavy minimum; while this option still contributes 3% of compensation to all employees, this is more predictable throughout the year and can help the retirement plan with other testing requirements, including ADP/ACP tests.
However, if all key employees defer less than 3% of compensation, the top-heavy minimum can be limited to the highest deferral rate. For example, if all key employees defer only 1%, the top-heavy minimum will be 1% for all non-key employees. Similarly, if no key employees defer to the retirement plan, the top-heavy minimum can be 0% as well, in effect eliminating any employer contribution requirement.
Are you seeking additional information about your retirement plan or wondering if your plan is subject to top-heavy retirement plan requirements? Contact the experienced retirement plan actuaries at Watkins Ross for a professional look into your retirement plan benefits. Together we’ll evaluate your retirement plan(s) for IRS compliance and ensure your benefit structure avoids unnecessary risk, requirements, and fees.