Who is Considered a Key Employee for a 401(k)? – Avoid This Mistake + FAQs

In a 401(k) plan, a “key employee” is someone who either owns a significant part of the company or holds a high-ranking position with a large salary.

This matters because if key employees account for more than 60% of plan assets, the plan is considered “top-heavy,” triggering special requirements. Below we dive into who qualifies as a key employee and why it’s crucial for your 401(k) plan’s compliance and fairness.

Key Takeaways:

• ✅ Who Counts as Key: Key employees include certain business owners (based on ownership percentage) and high-paid company officers, as defined by strict IRS criteria.
• ✅ IRS Criteria Thresholds: Owning >5% of the company (any salary), owning >1% with $150,000+ pay, or being an officer earning above a set annual limit (e.g. $220k in 2024) makes you a key employee.
• ✅ Impact on Plan: If key employees hold >60% of total 401(k) assets (a top-heavy plan), the company must contribute a minimum (usually 3% of pay) to all other employees and meet faster vesting schedules.
• ✅ Universal Rules: Key employee definitions are federal (IRS) rules that apply in every state – state laws don’t override 401(k) key employee criteria, though local factors (like community property) can indirectly influence ownership calculations.
• ✅ Compliance Matters: Misidentifying key employees or ignoring top-heavy rules can lead to failed tests, IRS penalties, or plan disqualification. Proper plan design (like safe harbor plans) and annual testing help avoid common pitfalls.

🔑 IRS Key Employee Criteria: Ownership and Compensation Tests

Under U.S. federal law (IRC §416), an employee is considered a key employee in a 401(k) plan if they meet any of the following tests during the plan year:

• More-than-5% Owner: The employee owns over 5% of the company (stock, capital, or profits). There’s no minimum salary required – even a 6% owner with a modest salary is a key employee.
• 1% Owner with High Compensation: The employee owns over 1% of the company and has annual compensation exceeding $150,000. (This $150k compensation threshold is fixed by law and not indexed for inflation.)
• High-Paid Officer: The employee is an officer of the company (a top executive role) with annual compensation above the IRS limit for that year. This officer salary threshold is inflation-adjusted most years (indexed in $5,000 increments).

For reference, here are recent officer compensation thresholds that trigger key employee status:

(If an officer’s pay exceeds the above amount for the year, they are considered a key employee.)

Keep in mind that this covers typical C-suite roles or anyone acting in an “officer” capacity. The term “officer” generally means a management executive with significant control or authority in the company, not just someone with a fancy title.

An employee with a VP title but no real executive authority might not count as an officer, whereas a key manager without an officer title could still be deemed an officer based on their duties. The IRS uses a facts-and-circumstances approach – looking at an individual’s authority, decision-making power, and role – to determine who is an officer.

So, titles alone don’t guarantee whether someone is a key employee; their actual role and pay do ✅.

Family Attribution Rule: Importantly, the IRS applies family attribution when determining ownership for key employee status. This means shares owned by certain family members are attributed to you. For example, if a business owner holds 100% of the company’s stock, their spouse, children, and parents (if they work for the company) are all treated as owning 100% as well.

In practical terms, a child or spouse employed by the business could be classified as a key employee even if they personally own no stock, because the owner’s ownership is credited to them. This rule prevents companies from circumventing the tests by transferring ownership to family – the law essentially sees the family unit as one for ownership purposes. 👪

Bottom line: if your immediate family members are owners, you might be a key employee by attribution.

Former Key Employees: Once someone qualifies as a key employee during a plan year, they’re considered key for that entire year. If their circumstances change (for instance, they sell shares and drop below the threshold or step down from an officer role), they won’t be treated as key in future years once they no longer meet any criteria.

These individuals become “former key employees.” Former key employees are generally excluded from ongoing top-heavy calculations after a certain period. In other words, the status isn’t permanent if the underlying condition (ownership or role) goes away. However, the tests look at the current and recent years, so someone who was key last year may still influence this year’s test if they were in the picture at the end of last year. The plan needs to keep track of such changes each year.

🏛️ State-Level Nuances: Do Key Employee Rules Vary by State?

401(k) plans are governed by federal law (ERISA and the Internal Revenue Code), which means the definition of a key employee is uniform across all states. No matter if your company is in California, Texas, or Maine, the IRS criteria for key employees remain the same.

Unlike some employment laws that vary by state, retirement plan nondiscrimination rules are federal and supersede state definitions. So, a “key employee” for 401(k) purposes means the same thing everywhere in the U.S. 🌎.

That said, state laws can indirectly affect details of plan administration. For example, in community property states, a spouse might legally own half of an owner’s interest in a business by default. This doesn’t actually change the federal key employee test – because of the family attribution rule, the spouse’s ownership is counted anyway – but it reinforces that both spouses may be treated as owners.

In practice, you don’t need to do anything different, since IRS rules already capture that situation.

Some states have started programs that mandate retirement savings options (like state-sponsored IRA programs for small businesses that don’t offer a 401(k)). In those state-run plans, the concept of “key employee” isn’t really relevant – those are typically simple Roth IRAs for employees.

But if a business decides to set up its own 401(k) to comply with state requirements, the same federal key employee rules apply. States cannot override or redefine who is a key employee in a qualified 401(k) plan due to ERISA preemption (which basically says federal pension law trumps state laws).

In summary, no state can change the key employee definition for a 401(k) plan. However, be mindful of how state-specific factors (like marital property laws or corporate governance rules) might influence who owns what in your company – those ownership structures will then feed into the federal tests. Always follow the IRS guidelines for key employees, regardless of your location, and you’ll be on solid ground 👍.

Key Employee Status: Impact on 401(k) Testing and Compliance

Identifying key employees isn’t just an academic exercise – it has real consequences for how your 401(k) plan must operate. Key employees come into play primarily in ensuring the plan doesn’t disproportionately benefit company insiders at the expense of rank-and-file workers.

Two major areas of impact are annual nondiscrimination tests and the resulting contribution and vesting requirements if those tests aren’t passed. Let’s break down the implications:

⚖️ The Top-Heavy Test: When Key Employees Tip the Scales

The top-heavy test is a yearly health-check for your 401(k) to see if key employees hold too large a share of the plan’s assets. Here’s how it works: on the last day of each plan year (the “determination date,” often December 31 for calendar-year plans), you calculate the proportion of total plan assets held by key employees versus everyone else.

If key employees together own more than 60% of the total account balances in the plan, the plan is considered “top-heavy.” In other words, the scales have tipped too far in favor of owners and officers. There’s no wiggle room – 60.01% is top-heavy, while 59.9% is not.

What triggers top-heavy status? Common scenarios include a small business where one or two owners’ accounts dwarf those of a few staff members, or a company where executives max out their 401(k) while lower-paid employees contribute little or nothing. For example, if three executives (all key employees) have $600k of the $1,000k total plan assets (60% exactly), the plan is on the brink. If the market grows those balances a bit more and they hit $610k out of $1,000k (61%), boom – you’re top-heavy 🔔.

Why does it matter? If a plan is top-heavy, federal law requires special corrective actions to protect the “non-key” employees (everyone else). The goal is to ensure lower-paid employees receive a fair minimum benefit since the plan is so skewed toward the keys.

Specifically, the employer must contribute a minimum amount to the accounts of all non-key employees for that year. Generally, the minimum contribution is 3% of each non-key employee’s total compensation for the year. (If key employees deferred a smaller percentage themselves, that lower percentage can be used as the minimum instead of 3%, but in most cases key folks contribute a lot, so 3% is the floor.)

This minimum contribution is often called the “top-heavy minimum” and is paid by the company, not by the employees. Notably, any 401(k) elective deferrals that non-key employees made on their own don’t count toward that 3% – it has to be an employer contribution on top. 💰

Another consequence: vesting must accelerate for a top-heavy plan. “Vesting” refers to how much of the employer contributions each employee owns outright based on their service. Under top-heavy rules, a plan must use at least one of the IRS’s accelerated vesting schedules for all employer contributions.

The options are typically either 3-year cliff vesting (100% vesting after 3 years of service), or a 6-year graded vesting (20% vested after 2 years, then 20% more each year until 100% at 6 years). If your plan already has a faster vesting schedule, great – but if it was slower (say a 5-year cliff), it will automatically be overridden by the faster top-heavy requirement for as long as the plan is top-heavy. This ensures non-key employees can fully own those required contributions relatively quickly.

Let’s illustrate the impact: Suppose Acme Co. is top-heavy – the owners (key employees) have 70% of the plan assets. In the following year, Acme Co. must contribute at least 3% of each non-key employee’s salary into their 401(k) accounts (even if those employees don’t contribute themselves).

If a non-key employee earns $50,000, that’s a $1,500 company contribution required for that year. All those contributions must become fully vested on that accelerated schedule (so the employee can keep the money even if they leave after a few years). These contributions are on top of any regular match or profit-sharing Acme might already do. Essentially, the company needs to spread some of the retirement wealth to the base of the pyramid to balance things out 😊.

What if the company doesn’t or can’t make those contributions? Failing to meet top-heavy minimums is a serious plan violation. The 401(k) could lose its tax-qualified status, which is a nightmare scenario – it means the plan’s tax benefits are revoked, potentially making all contributions taxable and undoing the plan’s advantages for everyone.

The IRS can impose penalties, and the company could face angry employees and lots of paperwork. Fortunately, there are correction programs (like the IRS’s EPCRS) to fix mistakes if a company realizes it missed a top-heavy contribution. But it’s far better to design the plan to avoid or automatically address top-heavy situations in the first place than to scramble in hindsight.

One way to avoid annual surprises is to include a provision in the 401(k) plan document that says “if we’re top-heavy, we will automatically contribute X% to non-key employees.” Many plans have this built in. Also, certain plan designs bypass the top-heavy test entirely – more on that below.

The key is awareness: each year, know whether your plan is top-heavy by doing the calculation, then follow through with the required contributions and vesting. This keeps your plan safe, compliant, and equitable.

Contributions, Limits, and Testing for Key Employees vs. Everyone Else

Even when a plan isn’t top-heavy, key employees (who are often the highest earners or owners) can face additional limits on how much they can contribute to their 401(k).

This is due to other nondiscrimination tests – notably the ADP/ACP tests – which compare the contribution rates of Highly Compensated Employees (HCEs) to those of Non-HCEs. It’s important to note that most key employees are also HCEs, but not always (e.g., an owner with 6% stake making $50k/year is a key employee by ownership, though technically also an HCE by ownership definition). For practical purposes, if you’re a key employee, you’re likely in the group whose contributions the IRS scrutinizes to ensure fairness.

Annual Contribution Limits: By law, every individual has a maximum 401(k) contribution limit (for example, $22,500 in elective deferrals for 2024, plus catch-up if over 50). Key employees don’t get a higher personal limit—the IRS cap applies equally.

However, in a plan with low participation from others, a key employee might not be able to contribute up to their personal legal limit. Why? Because if rank-and-file workers (non-HCEs) contribute very little, the ADP test will fail if HCEs (which include most key folks) contribute too much. To avoid failing, the plan will either restrict how much HCEs can defer or refund a portion of their contributions after year-end. From the key employee’s perspective, this feels like a limit on them specifically.

For example, suppose you’re a key employee who tried to max your 401(k) at 15% of pay, but your coworkers mostly put in 2% of pay. After the ADP test, you might get a notice that a chunk of your contributions are being returned to you (with earnings) because the disparity was too high.

Essentially, the plan rules ended up capping your effective contribution at a lower level (maybe you could only keep 6% of pay in the plan) to keep things proportional. This often comes as an unpleasant surprise to highly paid employees. In Reddit forums, you’ll find frustrated posts like “My 401k returned money to me because I’m HCE – what gives?!” This is directly tied to the presence of key/HCE individuals and not enough participation from others.

Key Employee ≠ HCE (But They Overlap): Let’s clarify the distinction: A Highly Compensated Employee (HCE) is defined by the IRS as owning >5% of the company or earning above a set dollar threshold (e.g., $155k in the prior year for 2023). A Key Employee (as we’ve covered) is defined by the ownership and officer criteria. All key employees who own >5% are automatically HCEs (ownership >5% triggers both definitions).

Officers making above the key threshold (say $220k) will also almost always be HCEs, since the HCE pay threshold is a bit lower (~$150k). The difference is that some HCEs might not be key employees – for instance, someone earning $200k with no ownership isn’t a key employee (unless they’re an officer), but they are an HCE by virtue of high pay.

Conversely, a 2% owner making $160k is a key employee (because >1% + $150k) and an HCE (because of pay). Why does this matter? Because “key employee” status drives the top-heavy test, whereas HCE status drives the ADP/ACP tests. Your plan administrator needs to identify both groups each year for different tests.

Plan Design Strategies: Employers who anticipate having key employees (especially in a small company) often take proactive steps. A popular approach is adopting a Safe Harbor 401(k) plan. A safe harbor 401(k) automatically satisfies the ADP/ACP nondiscrimination tests by the employer agreeing to make a certain minimum contribution for all employees (for example, a 3% nonelective contribution to everyone, or a matching formula like 100% of the first 4% employees defer).

If those conditions are met, the plan is exempt from ADP/ACP testing, meaning key employees/HCEs can max out their contributions without worrying about refunds. Bonus: A safe harbor plan that uses the standard formulas is also exempt from the top-heavy test in most cases – because the required contributions to non-keys are being made anyway, the plan is deemed to satisfy top-heavy requirements by default.

This is a huge relief for many small businesses: it lets the owners (keys) contribute the max to their 401(k) and automatically gives the staff a generous employer contribution, keeping everything compliant and equitable. Safe harbor plans essentially neutralize the key employee problem by preemptively leveling up the non-key contributions.

Other Compliance Considerations: Even if a plan isn’t safe harbor, companies can manage compliance by encouraging broad participation. Education and auto-enrollment can boost how much non-key employees contribute, which in turn allows key employees to contribute more without failing tests.

It’s a balancing act 🤹‍♂️. Some businesses also monitor mid-year – if the contribution gap is growing too wide, they might alert HCE/key employees to dial back contributions to avoid large refunds later.

Finally, remember that key employees show up in a few other regulatory contexts too. For instance, in certain benefit plans (like cafeteria plans or group life insurance), there are rules to ensure key employees don’t receive more than a fair share of tax-free benefits.

(One example: in a Section 125 cafeteria plan, if key employees receive more than 25% of the plan’s nontaxable benefits, those benefits become taxable to the keys – an incentive to keep plans balanced.) The point is, the concept of “key employee” reflects a general principle: preventing favoritism in tax-advantaged benefits. In the 401(k) world, that principle is enforced through top-heavy rules and contribution testing.

Staying Compliant: Avoiding Penalties and Plan Failure

For plan sponsors (employers), staying on top of key employee issues is a must for 401(k) compliance. If a plan consistently fails testing or ignores top-heavy minimums, the IRS can disqualify the plan – meaning all the tax deferral benefits unwind, and it’s as if the plan never existed as a qualified plan.

This is truly the worst-case scenario: employees would have to pay taxes on contributions, the company loses deductions, and a tangle of corrections ensues. Luckily, outright disqualification is rare and usually only happens if problems are willfully uncorrected or egregious.

The IRS offers correction programs like the Self-Correction Program (SCP) and Voluntary Correction Program (VCP) to fix mistakes, such as a missed top-heavy contribution or an improperly excluded key employee.

For example, if you discover that last year you should have given a 3% top-heavy contribution to an employee but didn’t, you can make a corrective contribution now (with interest) to make them whole. It’s important to act promptly – many errors can be self-corrected within two years. If you wait too long, it may require a more formal (and costly) IRS filing to correct.

The best strategy is to “bake in” compliance so you don’t have to fix things after the fact. Some best practices include:

• Annual Testing & Review: Mark your calendar to do the top-heavy test early each year (using last year’s data) and the ADP/ACP tests soon after the plan year ends. This gives you time to make contributions or adjustments before deadlines.
• Plan Design: Consider a safe harbor plan or add automatic enrollment or enhanced matching to encourage participation. These features can virtually eliminate the risk of failing discrimination tests or being top-heavy.
• Consult Experts: Work with a plan administrator or third-party administrator (TPA) who can identify who your key employees and HCEs are each year and run the tests correctly. They’ll also keep you updated on threshold changes (like that officer comp limit) so you don’t miss a new key person.
• Plan Documents: Ensure your plan document has up-to-date language on top-heavy provisions – it should outline what happens if the plan becomes top-heavy (e.g. “the employer will contribute 3% to non-key employees and comply with vesting requirements”). This way, there’s no confusion about the company’s obligation.
• Communication: If you do have to make top-heavy contributions, communicate to employees that it’s a benefit required by law to keep the plan fair. This can actually boost morale among non-key employees, who see extra money in their 401(k) when the plan is top-heavy 🎉. And key employees should understand these rules are the trade-off for maintaining their tax advantages.

By being proactive, you can avoid common pitfalls and ensure your 401(k) plan remains in the IRS’s good graces. A well-managed plan not only passes tests but also achieves the goal of helping all employees save for retirement – not just the folks at the top.

Real-World Examples and Case Studies

Sometimes it helps to see how all this plays out in real companies. Here are a few scenarios that illustrate key employee rules in action:

Example 1: Family Business Triggers Top-Heavy Status

Smith Architects LLC is a small firm with three employees: the owner (Alice Smith), her husband (who handles marketing part-time), and one junior architect. Alice and her husband are obviously key employees – Alice owns 100% of the company (making both of them key by attribution), and she’s the primary officer.

They each contribute the max to their 401(k), and over a few years their combined accounts grow to $300,000. The junior architect, meanwhile, is younger and only has $20,000 in her 401(k). At the end of the year, the plan’s total assets are $320,000, with the Smith family’s share being ~94% of that. The plan fails the 60% top-heavy test by a mile.

The next year, Smith Architects is required to make a minimum contribution of 3% of compensation to the junior architect’s account. Her salary is $70,000, so the company contributes $2,100 extra for her. They also ensure that her entire 401(k) balance will vest on a faster schedule (she’ll be 100% vested after 3 years with the firm). Alice doesn’t mind the extra contribution – it’s a small price for keeping the plan compliant, and it has the side benefit of rewarding her only non-key employee.

This example shows that in a family-run business, even relatives on the payroll become key employees due to ownership attribution, and the firm must be ready to contribute accordingly to others.

Example 2: Key Employee with Low Salary – Still Key

A tech startup, Innovate LLC, has two founders, each owning 50%. They don’t pay themselves much salary initially (let’s say $80,000 each) to conserve cash, and they have 8 other employees. Based on salary alone, the founders wouldn’t be HCEs in year 1 (since the HCE threshold was $150k+).

However, because each founder owns >5%, they are both key employees (and also HCEs via the ownership test). In the first year, few of the other employees contribute to the new 401(k) plan (most are young and opt out), but the founders contribute a decent chunk. As a result, by year’s end the founders’ accounts comprise about 65% of total plan assets – Innovate’s plan is top-heavy.

The founders were initially surprised: “We didn’t even pay ourselves six figures, how are we the problem?” But ownership is what did it. The company’s CPA advises them of the required 3% contributions and vesting changes. The founders decide to switch the plan to a Safe Harbor 401(k) for the next year, giving all employees a 3% nonelective contribution.

This automatically satisfies top-heavy and nondiscrimination rules going forward. The cost of the safe harbor contribution is worth it to them because now they and their employees can max out deferrals without testing worries. This example highlights that even moderate-income owners count as key; it’s not just about giant salaries. And it shows a common solution: use plan design to preempt issues once you recognize you have key employees and low participation among others.

Example 3: Mid-Size Company Fails ADP Test (HCE Refunds)

BetaCorp has 200 employees. The five highest-paid executives (each earning $250k+) are all key employees (they’re officers above the compensation threshold) and also HCEs. Many of the lower-paid staff contribute little to the 401(k). When BetaCorp runs its annual ADP test, it finds that HCEs deferred an average of 8% of pay, while the non-HCE group deferred only 2% on average. This gap is too wide to pass the IRS’s formula.

The plan fails the test. To correct it, BetaCorp must refund a portion of contributions to the HCEs (the key execs) to bring their effective deferral rate down, closer to the non-HCEs’. Each of the five execs gets a refund check of several thousand dollars, representing contributions that can’t stay in the 401(k) due to the failure.

The plan wasn’t top-heavy (since many employees had decent account balances from company profit-sharing), but it failed the ADP nondiscrimination test. This real-world outcome frustrated the executives – they lost some tax-deferred savings opportunity – and it signaled BetaCorp to improve participation. In response, HR rolled out an auto-enrollment feature for the 401(k) at 4% and increased their match to incentivize employees to contribute. The following year, with more non-key employees participating at higher rates, the tests passed and no refunds were needed.

This example shows that having key employees often correlates with testing issues even in larger plans, and highlights how addressing the broader employee engagement in the plan fixes the problem for everyone. The key employees in this story learned the hard way that a 401(k) plan must benefit the wider workforce, not just the top brass, if they want to fully enjoy their own contributions.

Example 4: Misidentifying an Officer – A Cautionary Tale

A company, Regional Bank Inc., thought only their CEO and CFO were “officers” for the key employee test. They overlooked that their highest-paid branch manager, who wasn’t labeled an executive, actually had significant operational authority over a region (and earned $200k/year). During an IRS audit, it was determined this manager functioned as an officer due to her decision-making power and management role, even though her title was “Regional Director.”

This meant she should have been classified as a key employee (officer exceeding the $185k threshold that year). Including her retroactively tipped the plan into top-heavy status for that year, and the bank had to make make-up contributions to non-key employees to correct the oversight. The lesson? Be careful in identifying who your “officers” are – it’s not solely about titles.

In this case, a non-C-suite individual was deemed a key employee once all the facts were considered. The company updated its internal procedures to evaluate officer status by job duties and compensation, not just by the org chart. This story underscores a pitfall: misclassifying personnel can lead to compliance surprises. Always apply the IRS’s functional definition of officer when determining key employees.

These case studies illustrate the challenges and solutions around key employees in 401(k) plans. Whether it’s a tiny family shop or a larger firm, the principles remain: identify your key people, test your plan, and take actions (plan design or contributions) to keep things fair. Real companies often learn through such scenarios, but you as a reader now have foresight to avoid the same mistakes 😃.

Common Mistakes and Pitfalls to Avoid

Successfully managing a 401(k) plan’s key employee issues requires attention to detail. Here are some common mistakes companies and plan administrators should watch out for — and tips on how to avoid them:

• Confusing “Key Employee” with “Highly Compensated Employee” – Don’t use these terms interchangeably. They are related but distinct groups with different tests. Pitfall: Assuming passing the ADP test means you’re fine, while ignoring the top-heavy test (or vice versa). Avoidance: Identify your HCEs and key employees separately each year. Remember, all key employees are considered in top-heavy testing even if they aren’t all HCEs by compensation. Know which rules apply to which group.

• Forgetting Family Ownership Attribution – It’s easy to overlook that an employee with no direct ownership might still be a key employee because their spouse or parent is an owner. Pitfall: Not counting a spouse on payroll as a key employee when their husband owns the company, for example. Avoidance: Always ask: “Does this employee have a family member who owns >5% or >1% of the company?” If yes, treat the employee as owning the same percentage for testing purposes. This prevents nasty surprises like a top-heavy failure due to an “innocent” family member’s account.

• Misidentifying Officers – Simply using job titles to decide who is an officer can mislead your key employee determination. Pitfall: Including someone as a key employee just because they have a VP title (when they actually have no significant authority), or excluding someone who lacks an officer title but in reality runs major operations. Avoidance: Use a facts-and-circumstances approach. Consider each individual’s role, authority, and responsibilities. If a person has the authority similar to an executive (hire/fire power, major financial decision-making, etc.) and a high salary, err on the side of classifying them as an officer for top-heavy testing. Conversely, if someone’s “Officer” title is honorary and they don’t really have executive powers, you may be justified in excluding them – but document why. When in doubt, consult with a plan consultant or ERISA attorney.

• Using Outdated Compensation Thresholds – The IRS updates the officer compensation limit for key employees every few years. Pitfall: A plan sponsor might still use an old number (say $170k) in 2024, causing them to miss that some new high-earner exceeded the real threshold ($220k) and should be counted as key. Avoidance: Stay updated with annual IRS limits. Each fall, the IRS publishes the next year’s limits for retirement plans. Make sure your HR or payroll team picks up changes to the key employee officer salary threshold, as well as HCE thresholds. Update any internal worksheets or software accordingly.

• Neglecting Annual Top-Heavy Testing – Especially in a small company, it’s easy to assume “we know the plan is top-heavy, it’s always been” or conversely “we’re small, it won’t matter.” Pitfall: Not actually running the numbers, which could lead to failing to make a required contribution or missing that the plan became top-heavy this year. Avoidance: Formally test the plan every year. Even if you’re pretty sure of the outcome, documenting the calculation is important. Things can change: an employee’s departure, a spike in the owner’s account balance, etc., can flip a plan into or out of top-heavy status. By doing the test, you catch it and can act.

• Missing Top-Heavy Minimum Contributions – Knowing you’re top-heavy is step one; step two is actually funding those 3% contributions to non-key employees. Pitfall: An employer realizes in June that last year was top-heavy but fails to go back and fund the required contributions for last year, or funds them for active employees but not those who left (plan document may require even former employees who left during the year still get the contribution if they were employed in that year). Avoidance: As soon as you determine top-heavy status, fund the required contributions (usually you’d add them to the profit-sharing allocation for that year or do a special contribution). Check your plan document – many plan documents say only people employed on the last day of the year get the top-heavy contribution, which is allowable. If that’s the case, you can exclude those who quit mid-year. But if not, you must give it to everyone who was in the plan that year. Timely correction is key to avoid IRS issues.

• Assuming a Safe Harbor Plan Can’t Be Top-Heavy – Safe harbor 401(k) plans are generally exempt from top-heavy testing if the only contributions are the safe harbor ones. Pitfall: If you make additional profit-sharing contributions or have other money in the plan, a safe harbor plan could technically still become top-heavy. Or if you didn’t exactly meet the safe harbor provisions one year, the exemption might not apply. Avoidance: Understand the conditions: if you follow the standard safe harbor formulas (and no extra contributions beyond that), you don’t have to do top-heavy testing. But if you go outside the safe harbor (like an additional discretionary profit share), do the top-heavy test just in case. It’s rare to see a safe harbor plan be top-heavy, but not impossible if, say, owners get large profit-sharing allocations.

• Not Communicating with Plan Advisors – Sometimes a company makes big changes (a new owner, a reorg of titles) and forgets to tell their TPA or advisor. Pitfall: The plan tester doesn’t know Joe was promoted to COO at $250k salary, so they miss counting him as a key employee. Avoidance: Keep open communication with whoever is doing your plan compliance. Notify them of any new owners, ownership percentage changes, or high-level hires/fires. They can only identify keys correctly with accurate data.

Avoiding these pitfalls largely comes down to diligence and communication. By understanding the rules and staying organized with annual testing and updates, you can steer clear of trouble. ✅

Pro tip: Create a simple checklist for each year’s 401(k) compliance: identify HCEs and key employees, run ADP/ACP tests, run top-heavy test, review outcomes, execute any needed contributions, and document everything. This checklist approach can save you from most of the above mistakes.

Pros and Cons of Key Employee Designation

Being classified as a key employee (and having key employees in your plan) has both advantages and disadvantages from a plan management perspective. It’s not a status one strives for or avoids like a personal choice – it’s a byproduct of one’s role or ownership. However, recognizing the pros and cons can help employers and employees alike understand the implications:

In summary, key employees come with built-in checks and balances. The “pros” largely accrue to the plan’s integrity and the broader employee base, ensuring fairness and encouraging thoughtful plan design. The “cons” usually fall on the employer and key group, in the form of added compliance work and limits or costs to keep the plan fair. By understanding both sides, companies can navigate the rules in a way that turns many of the “cons” into just the cost of doing business – and the “pros” into genuinely positive outcomes for the workforce.

FAQ: Key Employees and 401(k) Plans

Q: Is a key employee the same as a highly compensated employee (HCE)?
A: No. “Key employee” and “HCE” are defined differently. HCEs are defined by income ($150k+ in prior year) or >5% ownership, used for certain tests. Key employees are a stricter subset (owners and officers meeting specific criteria) used mainly for top-heavy testing.

Q: How do I know if I’m considered a key employee in my company’s 401(k) plan?
A: You are likely a key employee if you own more than 5% of the business, own more than 1% and earn over $150,000, or hold an officer position with a salary above ~$200k (the IRS limit for that year). Meeting any one of those is enough to be classified as key.

Q: Do key employees have special 401(k) contribution limits?
A: Not a separate legal limit – they can technically contribute up to the same IRS limits as anyone. However, in practice, key employees may be restricted by plan testing. If non-key employees save very little, the plan may force refunds or lower effective contribution limits for key employees/HCEs to stay within nondiscrimination rules.

Q: What happens if our 401(k) plan is top-heavy?
A: The company must take action to rebalance benefits. Specifically, the employer needs to contribute a minimum of 3% of salary (or equivalent) to each non-key employee’s account for that year (if any key contributed less than 3%, that lower rate can be used). Additionally, the plan must adhere to faster vesting for employer contributions (no longer than 3-year cliff or 6-year graded). These steps ensure the plan remains fair and keeps its qualified status.

Q: Can a business avoid top-heavy issues altogether?
A: Yes – the most common way is by adopting a Safe Harbor 401(k) plan. A safe harbor plan gives all employees a baseline employer contribution (like a 3% nonelective contribution or matching at 4%); in return, the plan is exempt from top-heavy and ADP/ACP testing. Additionally, encouraging broad employee participation (through auto-enrollment, education, etc.) can prevent a plan from becoming top-heavy or failing tests, because the more non-key employees contribute, the more balanced the plan.

Q: Does state law affect who is a key employee in our plan?
A: No. State laws do not change the federal definition of a key employee for 401(k) purposes. The IRS rules apply uniformly in every state. While state community property or business laws might influence ownership structure, the 401(k) plan still follows the IRS’s criteria for key employees and its federal testing requirements.

Q: Is a solo 401(k) (only one participant) considered top-heavy?
A: Technically, yes – if you’re the only participant and also the owner, you as a key employee hold 100% of plan assets, which is over the 60% threshold. But it doesn’t matter because there are no non-key employees to protect. Top-heavy rules have no effect when a business has no common-law employees aside from the owner (or owner and spouse). Solo 401(k) plans are essentially exempt by virtue of having no “other” employees.

Q: What is family attribution in determining key employees?
A: Family attribution means the IRS treats an employee as owning any share of the company that their immediate family owns (spouse, children, parents, grandparents). So, for example, if your spouse owns 100% of the company and you work there too, you are attributed that 100% ownership as well – making you a key employee even though you personally own nothing. It prevents companies from shifting stock to relatives to dodge the key employee label.

Q: Can someone stop being a key employee?
A: Yes. Key employee status is determined year by year. If an individual no longer meets any of the key criteria in a given year – for instance, they sold their ownership stake and are no longer a 5% owner, or they took on a different role and are no longer an officer – then for that plan year they wouldn’t be classified as a key employee. They would be considered a former key employee. Keep in mind, if they met the criteria last year, they were key for last year’s testing. But going forward, loss of ownership or position means loss of key status.

Q: Our company has only highly paid employees – do we still need to worry about these rules?
A: If you truly have no lower-paid or non-owner employees, then some tests become moot (you can’t discriminate if there’s no one to discriminate against). For example, a partnership of four highly paid owners with no other staff technically has key employees, but any contribution they make is going to key employees by default.

They’d still do a top-heavy test (and it will always be top-heavy), but since there are no non-key employees, there’s no one to give a top-heavy minimum to. Problems arise when there’s at least one non-key employee in the mix. The moment you have rank-and-file workers, the rules absolutely apply. So if you plan to grow by hiring more employees, keep these rules on your radar.