What are 401(k) Corrective Distributions?
posted by Fisher 401(k) March 27, 2019
In a 401(k) plan, corrective distributions happen when the company must return a portion of the contributions made by "highly-compensated employees" (HCEs). Highly-compensated employees are those who own 5% or more of the company, or will have earned more than $125,000 in 2019. The first quarter of the financial year is often referred to by financial industry professionals as “compliance testing” season. The IRS has rules for any 401(k) plan to ensure that no employee benefits unfairly. This can sometimes happen when highly-compensated employees contribute a significant amount more than “non-highly compensated employees” (NHCEs), or any other employee who doesn’t qualify as a highly-compensated employee.
We’ve written in the past about compliance testing and how you can make it through this sometimes difficult season more confidently—but there’s no reason to fear a failed compliance test. There are several ways to correct errors and earn passing marks, including corrective distributions. Let’s take a look at what corrective distributions involve, when you might encounter them as part of managing your company’s small business 401(k) plan, and how you can prepare for next year’s compliance testing.
What does “corrective distributions” mean, and why do they happen?
There are two compliance (also called nondiscrimination) tests that every 401(k) plan must pass each year in order to make sure that highly-compensated employees don't save at a much higher rate than everyone else. First, there’s the Actual Deferred Percentage (ADP) test, which looks at how much HCEs saved on average in pre-tax dollars from their salary compared to the rest of the company. Second, there’s Actual Contribution Percentage (ACP), which looks at employer contributions and after-tax dollars contributed by both groups.1
A 401(k) plan fails ADP testing when the highly-compensated employees as a group save more than 125% of what the other employees do.2 In order to pass ADP testing, the employer must make “corrective distributions” to HCEs in order to bring their average savings down to within 125% of the rest of the employees. For example, let’s say compliance testing on a 401(k) plan revealed that as a group, NHCEs contributed an average of 4% of their salary as pre-tax savings. The HCEs, on the other hand, saved 7%. The employer sponsoring the plan must then cut checks to the highly-compensated employees out of their retirement savings for that year. In doing so, they are essentially returning enough of the higher-paid employees’ excess savings plus estimated investment earnings for the year until the HCE average savings rate is down to 5% or less. This is a corrective distribution. Money returned in a corrective distribution then becomes taxable income.
When do corrective distributions happen?
Compliance testing takes place in the first few months after the end of the financial year. The IRS dictates that corrective actions must be made within 2.5 months of the year’s end.3 If your business operates on a January to December fiscal year, then, you will most likely encounter compliance testing and actions like corrective distributions between January and March.
How do I help prevent the need for corrective distributions?
While testing is required once a year, you don’t have to wait for the new fiscal year to evaluate your plan for its likelihood to pass. Many 401(k) providers will offer mid-year compliance testing at no additional cost, so you can spot any imbalance between HCE and NHCE savings long before the time will come to take corrective action. Another key quality of healthy 401(k) plans is good data. Make sure your 401(k) adviser has access to correct payroll data, and that you don’t let employee census information become outdated. Finally, there are some measures you can take to update your plan, like adopting a 401(k) Safe Harbor provision, so your plan automatically passes nondiscrimination testing.
As we mentioned above, ADP testing is only one part of compliance testing. When plans fail ACP tests, there are methods other than corrective distributions which can be taken in order to make sure every employee is receiving a fair benefit from your company’s retirement plan. Read our blog, 3 Tips for Surviving 401(k) Compliance Testing Season, for a deeper dive into everything that goes into both ADP and ACP tests, and for a closer look at the steps you can take to safeguard your plan against corrective distributions or other corrective actions.