Employee Benefit Plans: The 411

Valuable Information on 401ks, Pensions, ESOPs, Form 5500 Preparation + More

Why did I receive a refund of my 401k contribution?

refund, 401k, complianceIf you contributed to your 401k plan, then received a refund for a portion of your contributions for that year, chances are your plan failed the annual IRS required compliance (discrimination) testing. This test, or series of tests (based on your plan’s elections), provide for equal tax breaks to all participating employees – not just highly compensated employees (HCEs).

In general, the tests compare the contribution and deferral ratios of HCEs (as defined by the IRS) to those of the non-highly compensated employees (NHCEs) (as defined by the IRS). If the ratio of HCEs is greater than that of NHCEs by a certain amount, the plan is considered as failing and the percentages must be adjusted.

Making corrections

The most common methods the plan can follow to correct the failure are:

  1. The plan can contribute a qualified non-elective contribution (QNEC) to the NHCE’s to bring the ratios in compliance.
  2. 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 you would reduce the other NHCEs’ contributions until the ratios are in compliance and all HCEs end up having the same contribution for the year.

The latter option can pose a couple of issues to the participating employees.

Learn more about compliance tests

Consequences to participating employees

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. If you receive a refund, you must include the refund as taxable income in the year it was received, not the year you made the contribution. This requirement is unfavorable to employees who made contributions to increase their retirement funds and take advantage of the tax deferral opportunity. Remember, the refund is not a penalty to you, but a requirement mandated by the IRS to provide equal benefits to all employees.

Consequences to the employer

Generally, if the employer chooses to make a QNEC, and the QNEC is made prior to the end of the plan year, there is no consequence. If the employer chooses to refund excess contributions, they need to do so within two and a half 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, meaning the plan assets would be distributable to participants and included in their taxable income for that year.

How to avoid failing compliance tests

There are several strategies 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 auditor can also assist in explaining the accounting treatment for these strategies and corrective methods.

Victor Fuentes

Comments

  1. Mike says:

    I understand the compliance deal, and why I received a refund. Why is the 401k facilitators withholding 10% for the IRS as if it where an early distribution?

    Thanks.

    • admin says:

      Mike –

      It depends on the timing of the excess deferral refund. Any excess deferrals refunded subsequent to April 15 of the year following the year of the original deferral are subject to a 10% tax. Thank you for your interest in our blog.

      Kevin C. Bach, CPA, CVA

    • d says:

      I received a 401K excess contribution refund due to ADP testing. They took out federal and state taxes on the funds. The check was dated 4/15/16. Will I have to pay a 10% early distribution tax?

    • admin says:

      Thank you for your question and interest in our blog. ADP refunds are not subject to the 10% early distribution tax.

      Kevin C. Bach, CPA, CVA

    • Harry S says:

      I received a 401K excess contribution refund due to testing for the 2015 year. The re-distribution funds were sent to me before April 15th of 2016. The re-distribution wasn’t taken from my 2015 contributions. Instead they took from the funds I had contributed this year (2016). In addition, my company plan administrator withheld 10% of the amount for penalty on the excess contribution. Should I have to pay the excess penalty or my company?

    • admin says:

      Harry –

      Thank you for your question and interest in our blog. Refunds are not subject to the 10% early withdrawal penalty.

      Kevin Bach, CPA, CVA