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Corrective Distributions: An Unwelcome Refund

Updated: May 30

It’s the workplace retirement plan’s year-end and your company completed the required nondiscrimination testing. The results are in—failed. You now must tell some employees a specific amount of money they contributed to their 401(k) must be returned to them. They’re annoyed.

What about you? You’re also annoyed. This is a lose-lose situation. You’ve disappointed some employees and it’s an administrative burden for you. You’re now under a deadline to get the money returned, otherwise, the government is going to penalize you if proper action is not taken.

Sound familiar? Let's talk about what the issue is and how you can correct it.

What Are Corrective Distributions and What is the Cause?

Certain plans are required to conduct nondiscrimination testing. Why? The government wants to verify the plan is benefiting everyone, not just those who are highly compensated employees (HCEs). In 2023, an HCE is anyone who earns more than $150,000. It’s important to note anyone who owns 5% or more of the company, regardless of income, is also considered an HCE. This owner can be direct or by family attribution (i.e., spouse, parent, child, grandparent).

The two nondiscrimination tests conducted are called actual deferral percentage (ADP) and actual contribution percentage (ACP). Both tests are conducted to confirm non-HCEs are not being discriminated against in favor of HCEs. The ADP test looks at deferred wages and the ACP test looks at employer-matching contributions. Plans may also conduct a third test called the top-heavy plan test. The top-heavy test looks at the account balances of key employees to see if they exceed 60% of total plan assets. In 2023, key employees are officers making over $215,000, owners holding more than 5% of the business, or owners earning over $150,000 and holding more than 1% of the business.

If the plan fails the nondiscrimination testing, it will need to make corrective distributions. This means the plan will need to withdraw contributions, and possibly earnings, from the plan and refund them to the HCEs.

What is the Impact of Corrective Distributions?

The impact of corrective distributions is felt by both the employer and the employee.

For the employee, they’re deferring compensation to save for retirement, not to be returned the money right now. Not only will they need to be returned the money, but they will also be taxed on the entire amount. This money was earmarked for their retirement, possibly taken as a tax deduction, and put into a tax-advantaged account. What’s this mean? Not only do they have less saved for retirement than they were planning, but any tax planning done throughout the year could be in jeopardy. It also means the money that was supposed to be in a tax-advantaged account, 401(k), is now being returned to be put in a taxable account unless they leave cash sitting in a non-interest-bearing account—even worse!

For the employer, corrective distributions are a burden, as well. The plan has 2.5 months after the plan's year-end to correct the excess contributions. If the deadline is not met, the plan must pay a 10% excise tax on the total excess contribution amount. The plan is allowed to distribute the corrective distributions over the next 12-month period following the plan's year-end. If the distribution is not completed within 12 months following the plan's year-end, the plan is at risk of losing its tax-qualified status.

Aside from the administrative and legal aspects, employee morale can be greatly affected. A 2022 Glassdoor survey found 75% of employees say employee wellness with great benefits is extremely/very important. Making certain the workplace retirement plan is performing to the best of its ability is extremely important for talent retention. The study also found 58% of the most satisfied employees are either searching for or open to a new job if an opportunity arises. With benefits being an important factor and employees willing to leave, how can we prevent corrective distributions to avoid upsetting employees?

Corrective Distributions: Preventing an Unwelcome Refund

Performing nondiscrimination tests earlier in the year can help aid in preventing corrective distributions. Once the testing is complete, the HCEs can limit how much they contribute to the plan to pass ADP and ACP testing by the plan’s year-end.

Another method is by utilizing safe harbor plans since they have the potential to eliminate the need for nondiscrimination testing altogether.

A safe harbor 401(k) plan provides eligible participants with an employer contribution that is fully vested when made. In return, the plan is not subject to the annual nondiscrimination tests.

Traditional Safe Harbor Plan:

Basic match: Employer matches 100% up to 3% of employee’s compensation contributed, plus 50% on the next 2% of employee’s compensation contributed

Enhanced match: Matching contribution is at least as generous as the basic match. Typically, the employer matches 100% of the first 4% of the employee’s compensation contribution, not exceeding 6%

Non-elective match: The company matches 3% of employee compensation regardless of if the employee makes elective deferrals

Qualified Automatic Contribution Arrangement (QACA):

Safe harbor plans may contain an automatic contribution arrangement (ACA). This feature enables employees who fail to make an election to be automatically enrolled with a matching contribution unless they choose to opt out.

The plan must include an automatic contribution arrangement (ACA):

  • The default deferral rate starts at 3%, can be a maximum of 10%, and is required to increase at least 1% annually until it reaches 6%

  • The plan can continue auto increases up to 15%

  • After the first plan year following the date an employee is automatically enrolled, employers have the option, not obligation, to increase the deferral rate to 15%

  • If set at 6%, an annual escalation is not required

  • The QACA may apply a 2-year cliff vesting schedule

QACA basic match: Employer matches 100% up to 1% of employee’s contribution contributed, plus 50% on the next 5% of employee’s compensation contributed. (3.5% of compensation total)

QACA enhanced match: Matching contribution at least as generous as the basic match

QACA non-elective match: The company matches 3% of employee compensation, regardless of if the employee makes elective deferrals

Compared to traditional safe harbor plans, QACAs may not be as popular. Since most employees will more than likely defer compensation to receive the employer match a safe harbor plan provides, adding the administrative complexity a QACA entails may be challenging to rationalize.

What’s next?

Solving your plan’s corrective distributions may not be as complicated as you think. Talking to your plan provider will allow you to learn about the options available and any compliance aspects to take into consideration. Your plan provider and advisor can help you craft a well-designed workplace retirement plan to offer your plan participants.

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