Fixing Common Plan Mistakes - Top-Heavy Errors in Defined Contribution Plans


The Issue

Many of you have a 401(k) plan or some other form of defined contribution plan that needs to meet what are called “top-heavy plan rules.” These rules are found in section 416 of the Internal Revenue Code. The top-heavy rules are designed to ensure that lower paid employees receive at least a minimum benefit in plans where most of the assets are owned by higher paid employees (referred to as “key employees” and defined below). When a plan is top-heavy, certain minimum vesting and allocation requirements must be satisfied. Plans with fewer than 100 participants are the most likely to become top-heavy and thus affected by the top-heavy rules.

A key employee is an employee, who at any time during the plan year containing the determination date is:

  • A more than 5% owner of the employer (family attribution rules apply);
  • A more that 1% owner of the employer with annual compensation greater than $150,000 (family attribution rules apply); or
  • An officer with annual compensation greater than $215,000 for 2023 ($200,000 for 2022; $185,000 for 2021 and for 2020; $180,000 for 2019)

A defined contribution plan is top-heavy when, as of the last day of the preceding plan year (the determination date), the aggregate value of the plan accounts of key employees exceeds 60% of the aggregate value of the plan accounts of all employees under the plan. For top-heavy purposes, aggregate - not yearly - contributions and earnings are counted to ensure the top paid group does not benefit disproportionately. Note: It’s even possible for a plan to become top-heavy after a year in which no contributions are made.

If the plan is top-heavy, the allocation made to a participant in a defined contribution plan must satisfy certain minimum benefit standards. Generally, under a top-heavy plan, the allocation of a “non-key employee” must not be less that 3% of compensation for the entire plan year. Elective deferrals made by a non-key employee in a 401(k) plan do not count toward the 3% minimum. Generally, if the employee’s allocation is at least 3%, no further contribution is required to satisfy the top-heavy rules.

A top-heavy plan must also satisfy one of two minimum vesting schedules: the “three-year cliff” or “six-year graded” vesting schedule. A plan must state the vesting rules that will apply if the plan is top-heavy, even if the plan isn’t currently top-heavy. Under three-year cliff vesting, employees must be 100% vested once they have three years of service. Prior to completing the third year of service, the employee’s vesting percentage may be any percentage, including zero. Under six-year graded vesting, employees must be 100% vested once they have six years of service with certain minimum requirements for the interim periods.

The Problem

To properly comply with the top-heavy rules, unless the plan has been designed to satisfy the top-heavy rules in all years, employers must test their plans every year to determine their status. If the plan is top-heavy for a given year, the minimum benefits and vesting must be given for that year. The failure to properly follow the top-heavy rules can cause the plan to lose its qualified status.

Some commonly overlooked top-heavy rules that lead to problems include:

  • If the participant is a key employee at any time during the previous plan year, the person is considered a key employee for the entire year.
  • If the key employee account balances exceed 60%, the plan is top-heavy. There is no leeway.
  • The plan may provide that only employees employed on the last day of the plan year are entitled to the top-heavy contribution.
  • There is no 1,000 hour requirement in a defined contribution plan for a top-heavy allocation.
  • The top-heavy minimum contribution is based on a total compensation definition (not just compensation while a participant).
  • Elective deferrals made by a non-key employee to a 401(k) plan cannot be considered for the top-heavy minimum contribution.

The Fix

A top-heavy violation will cause a plan to become disqualified, resulting in adverse tax consequences to the employer and employees under the plan; however, employers may get relief from these adverse consequences through the Employee Plans Compliance Resolution System (EPCRS) by correcting the top-heavy failures. The Self-Correction Program (SCP) or Voluntary Correction Program (VCP) can be used to correct these mistakes. In order to fix the mistake under SCP, generally the mistake must be fixed within two years after the end of the plan year is which the failure occurred. Unless the failure can be classified as insignificant, VCP must be used after this time.

To correct a top-heavy allocation failure, the employer must make a corrective contribution on behalf of the employee who received an insufficient allocation in an amount equal to the insufficiency, adjusted for earnings. There is more than one way to correct a vesting failure under EPCRS.

Under the Contribution Correction Method, the employer makes a corrective contribution on behalf of the employee whose account balance was improperly forfeited by the amount of the improper forfeiture. The corrective contribution is adjusted for earnings. If, as a result of the improper forfeiture, an amount was improperly allocated to the account balance of another employee, no reduction need be made to the account balance of that employee.

Another way to correct these errors is the Reallocation Correction Method. Generally, the account balance of the employee who incurred the improper forfeiture is increased by the amount of the improper forfeiture and the amount is adjusted for earnings. The account balance of each employee who shared in the allocation of the improper forfeiture is reduced by the amount of the improper forfeiture that was allocated to that employee’s account.

Making Sure It Doesn’t Happen Again

Calculating the top-heavy status of a plan accurately and timely is vital for plan sponsors. The plan document, employee data, etc., should be carefully reviewed to ensure that the test is done correctly.

Important Tip: A plan can be structured so that the top-heavy minimum allocation requirement and vesting schedule is automatically satisfied every year. This eliminates the need to test for top-heavy status.

However, despite all of your good efforts, mistakes can happen. In that case, the IRS can help you correct the problem and retain the benefits of your qualified retirement plan.