If you contributed to your 401k plan during a year and then received a refund for a portion of your contributions for that year, then chances are your Plan failed the annual IRS required compliance (discrimination) testing.
To be brief, the IRS required compliance testing is a test or series of tests (The types of tests is based on your Plan’s elections) that provide for equal tax breaks to all participating employees, and not just highly compensated employees (HCEs). In general, the tests compare the contribution and deferral ratios of the HCEs (as defined by the IRS) to those of the non-highly compensated employees (NHCEs) (as defined by the IRS). These tests are commonly known as the ACP and ADP tests, and the mechanics of these tests is the subject of another conversation. If the ratios of the HCEs is greater than the NHCEs’ ratios by a certain amount, then the Plan will be considered as failing the compliance tests. The percentages must be adjusted in order for the Plan to pass the tests. The most common methods the Plan can follow to correct the failures are as follows:
- The plan can contribute a qualified non-elective contribution (QNEC) to the NHCE’s in order to bring the ratios in compliance.
- Refund excess contributions (plus earnings and minus losses) to the NHCE’s (based on IRS rules), beginning with the NHCE who has the highest dollar contribution for the Plan year, then reducing the other NHCEs’contributions until the ratios are in compliance, and all the HCE’s end up having the same contribution for the year. This is a very common method to correct a compliance failure but can pose a couple issues to the participating employee as discussed in the next section.
Consequences to Participating Employee of a Refund
The intended effect of the refund is to restore each participant and the Plan to the financial position it would have been in had the contributions been limited to pass the compliance tests in the first place. The participating employee receiving a refund will include the refund as taxable income in the year the refund was received, not the year the contribution was made. The requirement to include the refund as taxable income is unfavorable to employees, as they originally made the contribution in order to increase their retirement funds, and to take advantage of the tax deferral opportunity. However, it is important to acknowledge that the refund is not a penalty to the participating employee, but a requirement mandated by the IRS to provide for equal benefits to all employees.
Consequences to Employer
Generally if the Employer chooses to make a QNEC, and the QNEC is made prior to the end of the Plan year, then there is no consequence. If the Employer chooses to refund excess contributions, they need to do so within 2 ½ months after the Plan year end, otherwise the Employer will be subject to a 10% penalty on the calculated failure amount. If the failure continues to go unmitigated the Plan can lose its tax free status, in which the Plan assets would be distributable to Participants and included in their taxable income for that year.
How an Employer can avoid failing the Tests
There are several strategies that a Plan can initiate to mitigate or reduce the likelihood of failing the compliance tests. A compliance specialist should be contacted to assist with these strategies. Your Plan auditor can also assist in explaining the accounting treatment for these strategies and for the corrective methods discussed above.