How to avoid the pitfalls of a top-heavy 401(k) plan

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Proper plan design is vital to a successful retirement plan especially for small business owners. There are ways to attract and retain top talented employees without breaking the bank.

What are the implications or penalties when a 401(k) plan falls into top-heavy status? The plan must meet special minimum contribution and vesting requirements for non-key employees each year that the plan is deemed top heavy. The minimum contribution required to bring the plan back to compliance is the lesser of:

  • 3 percent of annual compensation for all non-key employees; or
  • A percentage equal to the highest percentage contribution of any key employee

Due to several factors, some plan sponsors may be concerned their 401(k) plans are currently headed into top-heavy status. The economic recession and financial meltdown of 2007-2008 forced many companies to cut salaries, downsize staffing and reduce or eliminate company matching contributions to their 401(k) plans. In reaction to these factors, some 401(k) participants have reduced or even stopped their contributions. Other participants have been forced to take financial hardships or full distributions as a result of job losses. When combining these factors with a plan whose key employees have maintained their contribution levels and seen their account balances improve as a result of the market’s recovery, it is a scenario that may cause the 60 percent top-heavy ratio to be compromised.

There are plan designs to help avoid the ‘Top Heavy” status for plans. These designs will require contributions to employees. It is recommended that the sponsor use a plan design which helps incentivize employees to increase their deferrals.

Please comment or call to discuss how this affects your organization.

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