What you need to know about top-heavy testing

Each plan year, retirement plan administrators must determine whether their plans are "top heavy" based on compensation to "key employees." What are these terms and why do they matter? Let's look at top-heavy testing for defined-contribution plans.

Who is a key employee?

A plan's top-heavy status is determined by performing a calculation that compares the total account value of key employees to the total account value of all employees. To perform top-heavy testing for a plan, you'll need to compile employee census data for the reporting period. From this data you'll identify key employees.

A key employee is:

  • An officer of the company whose compensation is more than $160,000 (in 2011),
  • An employee who owns more than 5% of the company either alone or through stock attribution (regardless of compensation), or
  • An employee who owns more than 1% of the company either alone or through stock attribution and earned more than $150,000 during the determination year.

Correctly identifying the key employees is essential in determining a plan's top-heavy status.

How are plans tested?

Generally, plans perform top-heavy testing at the same time as the plan's year end reporting. Your plan document must outline its top-heavy rules. Make sure to review your plan document before performing the top-heavy test.

Many plan sponsors use software or spreadsheets specifically for top-heavy testing. Generally, the test considers account balances as of a determination date, adds back certain distributed amounts or contributions, and subtracts certain rollovers into the plan and other excluded transactions.

For existing plans, the determination date is the last day of the prior plan year. For example, if you're trying to determine whether an existing calendar-year plan is top heavy for the 2011 plan year, the determination date is Dec. 31, 2010. For both the first and second plan years of a new plan, the determination date is the last day of the first plan year. For example, when determining whether a new calendar-year plan is top heavy for 2011, the determination date would be Dec. 31, 2011, for both the 2011 and 2012 plan years. Therefore, for new plans, you may not know whether the plan is top heavy until after the plan year is over.

What is top heavy?

A plan is deemed to be top heavy if on the determination date the total account value of key employees exceeds 60% of the total account value of all employees in the plan. If the plan is top heavy, the plan administrator must make top-heavy minimum contributions to all nonkey participants employed as of the last day of the plan year.

The top-heavy minimum contribution is the lesser of 3% of the total compensation for the plan year (regardless of the plan's definition of compensation) or the highest key employee contribution percentage during the plan year. Key employee contributions include elective deferrals and any forfeitures allocated to the key employee but don't include catch-up contributions. If there weren't any contributions made for key employees, you don't need to make top-heavy minimum contributions.

What transactions are included?

Some transactions are included in the top-heavy calculation and some aren't included. For example, included are:

  • Distributions processed during the plan year ending on the determination date for any participant who completed service in that plan year,
  • In-service distributions (such as distributions when participants reach age 59½ or hardship distributions) for reasons other than death, disability or termination of employment for five years (beginning with the plan year ending on the determination date and going back four years),
  • Any receivables for the first plan year only, and
  • If you use the accrual accounting method, possibly profit-sharing receivable contributions.

But not included are:

  • Account balances belonging to participants who terminated employment in a prior year,
  • Distributions processed during the plan year for participants who terminated employment in the plan year, or
  • Unrelated rollover contributions to the plan.

The calculation also excludes catch-up contributions for the plan year in which they were made. However, these contributions are included in future plan years as part of the participant's account balance.

Don't get top heavy

Top-heavy determinations aren't simple, so you may want to consult your benefits specialist. If your plan is top heavy and you fail to make the required contributions, your plan could become disqualified and face undesirable tax consequences. Depending on the mistake, you may be able to correct through the self-correction program (SCP) or the voluntary correction program (VCP).