If 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.
The most common methods the plan can follow to correct the failure are:
- The plan can contribute a qualified non-elective contribution (QNEC) to the NHCE’s 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 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.
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.