What Corrective Distributions May Indicate About Your Retirement Plan Design

The U.S. government introduced the 401(k) retirement plan option in the late 1970s as a benefit for all workers. To prevent company 401(k)s from simply becoming a tax shelter for highly compensated employees, the government requires plan sponsors to conduct annual nondiscrimination testing. The results of this annual compliance testing may require the company to make certain corrective distributions or additional contributions to non-highly compensated employees to ensure that the 401(k) plan does not favor highly paid employees or company owners.

Why Do Companies Conduct Nondiscrimination Testing?

Companies conduct annual nondiscrimination testing that compares the proportion of salary deferrals and contributions made by owners and managers ("highly compensated employees," or HCEs) to those made by lesser-paid employees ("non-highly compensated employees," or NHCEs).

In 2024, anyone who earns more than $155,000 is considered an HCE for the purposes of nondiscrimination testing. Additionally, anyone who owns five percent or more of the company, either directly or by family attribution, is also considered an HCE, regardless of their total compensation. The ownership through family attribution category applies to employees related to a five percent owner, such as a spouse, child, parent, or grandparent. These individuals must also be treated as HCEs.

How Is Nondiscrimination Testing Performed?

Each year, companies must perform two tests to ensure that the 401(k) plan does not favor highly compensated employees. These tests are called the Actual Deferral Percentage (ADP) and the Actual Contribution Percentage (ACP). The ADP test measures the amount of income employees defer into their 401(k) accounts, making sure that HCEs are not disproportionately contributing to the plan compared to NHCEs. The ACP test assesses employer contributions to the plan, to measure how much HCEs receive in matching contributions versus NHCEs. The specific calculations for nondiscrimination testing should be detailed in the plan document and comply with IRS regulations.

What Are 401(k) Corrective Distributions?

If a plan fails its nondiscrimination testing — meaning an oversized proportion of contributions were made by HCEs — it generally needs to make a so-called corrective distribution by withdrawing contributions and sometimes earnings from the plan and refunding them to the HCEs. The HCEs must then pay tax on those refunded amounts. A plan has two-and-a-half months after the end of the plan year to correct excess contributions for that year. If it fails to meet that deadline, it must pay a 10% excise tax on the excess contribution amount.

Beyond the sheer hassle of making a 401(k) corrective distribution, the plan sponsor also must report any distributions on its annual Form 5500 filing. Unfortunately, a corrective distribution often indicates the need for a better 401(k) plan design or a more knowledgeable retirement plan service provider. In fact, an IRS study found that 10% of corrective distributions were handled incorrectly.

When Do 401(k) Corrective Distributions Occur?

Required compliance testing for 401(k) highly compensated employees may occur at different dates during the calendar year, based on the company's fiscal year-end. If the plan does not pass the required nondiscrimination tests, distributions must be made within 2.5 months after the plan's year-end to avoid paying the 10% excise tax. For companies running on a calendar-year basis, this means necessary corrections need to be made by mid-March. If this deadline is missed, the plan may distribute excess contributions for the rest of the 12-month period following the end of the plan year and pay the excise tax. If the required distributions are not made by the end of the 12-month period, the plan could be in danger of losing its tax-qualified status.

How Can Businesses Prevent Corrective Distributions From a 401(k) Plan?

Companies may choose to run 401(k) testing for highly compensated employees at midyear to avoid the need for a corrective distribution. At this point, action can be taken to limit HCE contributions to the plan to meet the necessary ADP and ACP limits by year-end. If there are concerns about the potential need for corrective distributions, companies should talk to their plan providers about performing nondiscrimination tests earlier in the year.

Another option is a shift in status to a safe harbor 401(k). The addition of a safe harbor provision to a 401(k) plan enables an employer to skip the required annual nondiscrimination testing, as long as the employer provides contributions to employee accounts that are fully vested. This can be done by using one of the following plan structures:

• Safe harbor match — Employees must contribute to the 401(k) plan and their contributions are matched by the employer.
• Non-elective safe harbor — Employees are not required to contribute to the plan, but the employer still makes contributions on their behalf.
• Qualified auto-enrollment — Employer contributions may occur through a match or a non-elective contribution, according to IRS rules.

Designing a Better Retirement Plan

It's important for plan sponsors to pay attention to Form 5500 filing requirements as well as nondiscrimination testing rules when designing their 401(k) plan. An experienced retirement plan provider with expertise in plan design and compliance rules will work with you to ensure you pass nondiscrimination tests and don't make mistakes with a corrective distribution.

Paychex, the nation's largest 401(k) plan provider by total number of defined contribution plans, performs comprehensive evaluations of account balances and quarterly nondiscrimination testing to help its clients adeptly manage their retirement plan. Plan design experts can evaluate your current plan and identify opportunities for improvement.

Having a well-designed retirement plan is essential to recruiting the best and brightest employees in today's competitive job market, as well as retaining key talent. Don't settle for less when managing this important benefit. Select a 401(k) services provider that stays on top of the latest government requirements and provides the expertise and processes needed to ensure your plan is top-of-the-line.