If you have been notified that your plan has exceeded (or is at risk of exceeding) IRS nondiscrimination testing limits or if you’re a participant in such a plan, this article is designed to help you understand how nondiscrimination testing affects you. If you need a primer on how nondiscrimination works, check out our related article here.
Corrections are simple and may involve: a) a refund of excess deferrals to owners and highly compensated employees, b) a company contribution to non-highly compensated employee accounts, or c) a combination of these two options. Corrections to a plan exceeding IRS nondiscrimination testing limits are a routine matter. As long as corrections are completed by the IRS deadline, there are no penalties. However, failure to make timely corrections to your plan will lead to IRS imposed penalties and increased correction costs.
Here’s a look at the correction methods available for the ADP, ACP, and Top Heavy Tests.
Make ADP Corrections
A plan exceeds ADP (Actual Deferral Percentage) limits when the discrepancy between the average employee deferral rate of HCEs and the average employee deferral rate of NHCEs exceeds the IRS allowed disparity. To fix an excess ADP ratio, the company can make contributions to non-HCEs or refund excess contributions to your HCE group.
- Employer Contribution: The employer can make Qualified Non-elective Contributions (QNECs) to the 401(k) accounts of NHCEs, effectively increasing the deferral percentage of NHCEs to bring a plan within ADP limits. Contributions can be allocated in a number of different ways including:
- pro-rata based on compensation,
- targeting the NHCEs with the lowest compensation or deferral rates first,
- matching the NHCEs who contributed, or
- contributing the same dollar amount to all NHCEs.
- Refund Excess Contributions: Alternatively, refunds can be issued to HCEs. The HCEs who have contributed the largest dollar amounts will receive larger refunds. Refunds are issued after the end of the year and are taxable as ordinary income in the year distributed (not the year contributed). For the employee receiving a refund, their W-2 income remains unchanged, but the employee will receive a 1099-R the following January to report the taxable amount. These 401(k) refunds are not subject to early distribution penalties if they are made by the applicable date (March 15th for most plans). By default, federal tax of 10% is withheld and employees can elect to have additional tax withheld.
These two corrective methods – contributions and refunds – can be used in combination.
Make ACP Corrections
The ACP (Actual Contribution Percentage) test is nearly identical to the ADP test except that it compares the employer matching contributions that your company made to HCEs (as a percentage of their W-2 compensation) to the contributions made to NHCEs. As with ADP failures, ACP failure can be corrected with:
- Contributions to NHCEs which are included in the calculation of contribution amounts.
- Refunds of excess contributions to HCEs.
Again, contributions and refunds can be used in combination to correct your plan.
Make Top Heavy Corrections
Top Heavy testing failure occurs when balances in the 401(k) accounts of key employees — like owners and executives — exceed 60% of total plan assets measured at the end of the prior year (or the end of the year for first year plans).
Top Heavy failure can be corrected by making contributions to eligible non-key employees who are employed on the last day of the year. These Top Heavy contributions must equal or exceed one of the following:
- 3% of each non-key employee’s W-2 income, or
- The highest contribution percent of any key employee.
If nonkey employees receive matching, profit sharing, or QNECs, these can count toward the minimum contribution.
Top Heavy contributions can be subject to vesting and must be made in a timely manner.
Correct Excess Contributions Under § 402(g)
Employee deferrals to 401(k) plans are limited to $19,500 per year as of 2020. Those over 50 years old can contribute an additional $6,500 as a catch up contribution. This limit applies on an individual level, so those participating in multiple plans will be limited to $19,500 for the year. Guideline monitors participant contribution limits within the plan. However, if an employee changes employers and/or contributes to multiple plans during a given year, it can be possible to exceed this limit.
Excess deferrals (adjusted for earnings) are simple to correct. They are distributed to employees by April 15 of the following year and reported as income in the year the deferrals were made.
Correct Excess Contributions Under § 415(c)
Section 415(c) of the Internal Revenue Code requires the total combined employee deferrals (pre-tax and Roth) and employer contributions (including matching and profit sharing) to be limited to an annual limit of the lesser of 100% of compensation or $57,000. This limit applies to all plans sponsored by the employer, including related employers. However, an employee who participates in more than one plan sponsored by unrelated employers over the course of a year would have a separate § 415 limit for each plan.
Employee deferrals that exceed the limit will be refunded to the employee. Employer matching funds exceeding the limit are forfeited to the plan and used to pay plan expenses.
We’re here to help!
Guideline monitors your 401(k) plan throughout the year and will alert you if your plan is at risk of falling outside IRS compliance limits. Guideline specialists are ready to discuss your correction options with you.