In order to make sure that the plan is fair to all employees and not just the highly compensated employees (HCEs) or key employees, the IRS mandates that the plan satisfy nondiscrimination tests each year. These rules are just to make sure that employees have been made aware of the plan, are taking advantage of the plan, and are receiving equal benefit from the plan.
A plan that is "top heavy" has more than 60 percent of assets coming from key employees. Key employees are employees that are at least 5-percent owners of the company, earn more than $85,000, or had a salary that ranked in the top 20 percent of salaries within the company.
What it boils down to is that the non-highly compensated employees have to contribute at a rate that is proportionate to that of the highly compensated group. If lower-paid employees' contributions are lower than expected, then the highly compensated employees will be limited in how much they can contribute. This is partly why employers work so hard to get employees to participate in the 401(k) plan -- if those lower-paid employees don't contribute much, then the higher paid employees (such as executives and owners) can't contribute much, either.
If the plan is top heavy, then the employer has to work to correct the problem by either lowering the HCE's contribution limit or contributing more to the non-HCE's accounts. There is also a Safe Harbor option, which is simply another way of ensuring balance within the plan. The Safe Harbor method lets employers skip the nondiscrimination tests if they immediately fully vest employees and meet the following contribution requirements:
- Every non-HCE receives a 100-percent match on contributions they make that are up to three percent of their total salaries, and a 50-percent match on contributions they make that are from three percent to five percent of their salaries.
- The rate of matching contributions being made to HCEs cannot be higher than that made to non-HCEs.
As an alternative, an employer can make nonelective contributions equal to three percent of all eligible employees' salaries -- even those not participating in the plan.
Employers are required to submit Form 5500 annually to the IRS. This form provides reports and statistical information about the plan and its sponsors, and provides proof of compliance with the 401(k) legal requirements.
For more information on 401(k)s and related topics, check out the links below.
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