By Ian Berger, JD
IRA Analyst

Just like eating too much pumpkin pie with whipped cream isn’t good for your waistline, being a “top-heavy” retirement plan also may not be healthy.

Sponsors of certain retirement savings plans must have their plan tested each year to determine if it is “top-heavy.” The top-heavy test is designed to make sure that lower-paid employees receive at least a minimum benefit if most plan assets are held for higher-paid employees.

Section 401(k) plans are subject to top-heavy testing, unless the plan uses a “safe harbor” contribution formula. SEP-IRAs are also subject to testing, but most will automatically comply. Section 403(b) and 457 plans and SIMPLE IRAs are exempt from the top-heavy test.

A plan is considered top-heavy for a particular year if the total value of the plan accounts of “key employees” is more than 60% of the total value of all accounts. This calculation is done as of the last day of the previous year (usually December 31).

A key employee is:

  • An officer making over a certain dollar limit ($185,000 for 2020 and $180,000 for 2019);
  • A more-than-5% owner of the company; or
  • A more-than-1%-owner who also earns over $150,000 for the plan year.

Ownership is determined using family aggregation rules.

If a plan is top-heavy, the employer must usually make a contribution of at least 3% of pay for all non-key employee participants still employed on the last day of the plan year. (However, in the unlikely event that the largest contribution of pay percentage – taking into account both employer contributions and elective deferrals – for any key employee is less than 3%, only that smaller contribution percentage needs to be made for non-key employees). The minimum contribution can be subject to a vesting schedule.

Example: Company A sponsors Plan A, a 401(k) plan. As of December 31, 2019, the account balances of the key employees was $200,000, and the total account balances was $300,000. The plan is top-heavy for 2020 because the total value of the plan accounts of key employees as of December 31, 2019 was 66.67 % of the value of all accounts.

For 2020, the largest contribution of pay percentage, taking into account both employer contributions and elective deferrals, for any key employee is more than 3%. Therefore, Company A must make an employer contribution of at least 3% of pay for all participants employed on December 31, 2020 who are non-key employees.

Don’t confuse the top-heavy rules with two other nondiscrimination rules that many 401(k) plans must satisfy each year. The first of those tests, the ADP test, compares the elective deferrals made by high-paid employees to deferrals made by other employees. The second test, the ACP test, compares matching contributions and after-tax contributions for the two groups. Sponsors of 401(k) plans can use a “safe harbor” contribution formula to avoid these tests – as well as the top-heavy test.

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