Many 401(k) plan sponsors are disappointed to learn of a plan’s status as a top-heavy plan. Employers adopting 401(k) plans to permit only employee deferrals, or possibly a matching contribution, are often unprepared to satisfy the contribution required to comply with the top-heavy rules.

A plan generally is top-heavy if at least 60% of plan balances belong to key employees (certain owners and officers) on the last day of the prior plan year. A top-heavy plan is required to provide a contribution for non-key employees equal to the lesser of 3% of compensation or the greatest percentage contributed (including 401(k)) on behalf of any key employee for the plan year.

Consider the following small plan which became top-heavy. From the owner’s perspective, the $3,600 contribution required to satisfy the top-heavy requirement significantly increases the ‘cost’ of the plan.

Employee	Age	Salary	401(k)	Top-heavy Contribution
Owner	50	$150,000	$13,000	$0
Employee	40	$50,000	$5,000	$1,500
Employee	35	$40,000	$0	$1,200
Employee	30	$30,000	$1,000	$900
Total			$19,500	$3,600

Traditionally, employers were told of two options for dealing with a top-heavy 401(k) plan. First, the employer could forbid 401(k) contributions from key employees. This was designed with two desired effects. First, if no key employee contributes during a plan year, no top-heavy contribution is required. Second, if non-key employees are the only ones contributing, the plan may cease to be a top-heavy plan in the future.

Key employees are often the most important employees, and probably the primary reason the plan was established. An employer faced with forbidding contributions by key employees would often rather terminate the plan entirely.

If key employees are to continue contributions the employer’s only option is to contribute the top-heavy contribution. The employer should, in that case, consider changes to the plan that could help reduce the effect of top-heavy status.

Contribute the Top-heavy Contribution to All Participants. The top-heavy rules require the 3% contribution for non-key employees. However, nothing prohibits the employer from contributing on behalf of key employees. In the above example, the employer could provide the top-heavy contribution to the owner. The allocation of $4,500 to the owner may make the $3,600 contribution for employees seem less burdensome.

Consider 401(k) Safe Harbor Status. A plan is deemed to satisfy the top-heavy rules if it satisfies a 401(k) safe harbor. 401(k) safe harbors are designed to exempt a plan from the discrimination tests which act to limit 401(k) deferrals and matching contributions on behalf of highly compensated employees (the “ADP” and “ACP” tests). A plan satisfies the 401(k) safe harbor if it provides a fully-vested contribution of 3% of compensation for all participants or matching contribution generally equal to 100% of participant 401(k) contributions not in excess of 4% of compensation.

If a top-heavy plan traditionally has problems satisfying the ADP and/or ACP tests, the employer should consider 401(k) safe harbor status as a solution to both its top-heavy and ADP/ACP problem. In the above example, notwithstanding the plan’s top-heavy status, the plan faces an ADP test problem. The owner contributes 8.67%. The employees’ average 4.44% The ADP test would permit the owner’s contribution to be no more than 6.44%. To satisfy the ADP test, a taxable distribution of $3,345 would be required.

If the plan was a safe harbor plan, it would be required to provide a 3% of compensation, fully vested contribution. The $3,600 contribution calculated for top-heavy would satisfy the 401(k) safe harbor. The employer would be deemed to satisfy the ADP test and no distribution would be required and the plan’s compliance with the safe harbor rules would satisfy the top-heavy requirements. In addition, the owner could still receive the $4,500 contribution on his own behalf discussed above.

Consider a Tiered Allocation Formula. Many employers do not understand the advantages of a tiered, or new comparability, plan. Depending upon the relative ages of employees, the owners could receive an allocation of 9% of compensation while only providing an allocation of 3% for employees. Thus, an employer sponsoring a top-heavy plan can satisfy the top-heavy contribution requirement via the 3% contribution for employees while providing a much larger, fully deductible, contribution for the owners. In addition, that same 3% contribution for employees can also be used to satisfy the safe harbor 401(k) requirements (provided it is fully vested). Thus, the plan could also solve any ADP/ACP problems.

Based upon the above example, the owner could provide the 3% contribution for employees (which would satisfy the top-heavy and safe harbor requirements) and make a 9% of compensation contribution on his own behalf. The ability to contribute $13,500 to his account should help offset the cost of contributing $3,600 for the employees.

Employee	Age	Salary	401(k)	Contribution
Owner	50	$150,000	$13,000	$13,500
Employee	40	$50,000	$5,000	$1,500
Employee	35	$40,000	$0	$1,200
Employee	30	$30,000	$1,000	$900
Total			$19,500	$17,100

For most employers faced with a 3% top-heavy contribution, consideration of a tiered allocation should be an essential step. The owner’s ability to allocate a larger percentage of contributions to his own account enables many employers to satisfy the top-heavy and safe harbor contributions while not considering them to be a burden on the employer’s finances.

Timing of Changes. While the solutions set forth in this article are designed to help soften the blow of top-heavy status, they may not be able to help right away. Please keep in mind that safe harbor status is elected before the plan year starts. In addition, a tiered, or new comparability, allocation formula must be documented in the terms of the plan generally before the plan year ends.

In the above example, if the plan sponsor learns in 2004 that the plan was top-heavy for 2003, the sponsor’s options are constrained by the terms of the plan in effect for the 2003 plan year. This would likely permit the 3% contribution for the owner, but would not permit a tiered, or new comparability allocation, and would not permit safe harbor status for 2003.

In addition, if the plan was top-heavy in 2003, it can probably be assumed that it will remain top-heavy for several years. In that case, the sponsor’s options for 2004 are less constrained. For example, the sponsor could amend the plan to provide a tiered, or new comparability, allocation formula, but could not elect safe harbor status until 2005.

There are no easy answers for how to handle a plan’s top-heavy status. However, there are options and employers are encouraged to seek competent advice before making any decisions.