Receiving a refund is usually the preferred solution when something doesn’t work out for the consumer. In the case of 401(k) plans, however, refunds aren’t necessarily a good thing. If a 401(k) plan fails required nondiscrimination testing, the business owners and higher paid employees may have to take a taxable refund of some of the salary deferrals they put into their plan account.
As a 401(k) plan sponsor, you are responsible for ensuring that your plan passes the Actual Deferral Percentage (ADP) test and the Actual Contribution Percentage (ACP) test each year. These tests ensure that the contributions made to your plan do not disproportionately benefit your highly-compensated employees (HCEs). If your plan fails either test, you must take corrective action to maintain the tax qualification of your plan.
Correction Options and Deadlines
If your plan fails the ADP or ACP test, you must follow the corrective measures described in your plan document. Options for correcting failed tests include:
- Making additional contributions to raise the non-HCE group’s ADP or ACP enough to pass the applicable test, or
- Distributing excess contributions to HCEs
Making distributions to HCEs is the most common method for correcting ADP/ACP testing failures. Testing excesses, plus earnings, that are refunded to an HCE are taxable to the HCE in the year distributed. These distributions may not be rolled over to an IRA or other retirement plan.
The longer you wait to correct a testing failure, the more it could cost.
If distributions are made within 2½ months after the plan year end (by March 15 for calendar-year plans), there will be no additional costs for the plan sponsor.
If distributions are made more than 2½ months after the plan year end, the plan sponsor will have to pay a 10% nondeductible excise tax on the excess contributions. For plans with an eligible automatic contribution arrangement (EACA), there is generally no excise tax unless distributions are made more than 6 months after the plan year end.
If distributions (or other corrective actions) are not made within 12 months following the plan year end, the failure may result in plan disqualification. However, plan sponsors may be able to avoid disqualification by correcting the failure using the IRS Employee Plans Compliance Resolution System (EPCRS).
How to Avoid ADP/ACP Testing Failures
To help your plan avoid ADP/ACP testing failures, you may want to consider taking the following steps:
Newport Group Solution:
- Develop employee education initiatives designed to increase both plan participation and salary deferral rates among lower paid workers
- Explore the safe harbor 401(k) plan design feature that is deemed to satisfy the ADP/ACP testing requirements or other plan design features that are intended to increase participation and contribution rates, such as automatic enrollment and automatic escalation
If you have questions about testing results or the corrective options available under your plan, contact your Newport Group Representative.
Make Sure You Know Your Plan’s Definition of “Compensation”
One of the most common compliance problems identified by the IRS is that plan operations do not follow the definition of compensation described in the plan document. Plan sponsors have an ERISA fiduciary responsibility to make certain that plan operations follow the terms set forth in the plan document. Using an incorrect definition of compensation could affect many different aspects of plan administration, including nondiscrimination testing and plan contributions. For example, if an incorrect definition of compensation is used, participants may receive allocations to their accounts that are either greater than or less than the amount they should have received.
Determining compensation can be challenging because more than one definition may apply per plan, for different functions. IRS regulations dictate the definitions of compensation that must be used for certain plan functions. While there are some minor variations permitted in these statutory definitions of compensation as to whether they include or exclude certain types of fringe benefits, they will generally reflect a participant’s W-2 compensation.
The plan document can further define compensation for other purposes such as allocating employer contributions. The plan's definition can be the same as a statutory definition, or it could be a modified definition so long as it is determined to be reasonable and nondiscriminatory. Modifications typically exclude certain sources of income, such as bonuses, overtime pay or commissions.
A plan document may also apply different periods for measuring compensation. A participant’s compensation may be measured over the plan year, the calendar year, or the employer’s fiscal year. And, for newly eligible employees, the plan may only consider compensation a participant earned since entering the plan.
Determining compensation for plan purposes can be complex. The IRS provides the following tips to help plan sponsors avoid compensation-related failures.¹
- Review your plan document’s definition of compensation for each plan purpose
- Use the statutory definition of compensation when required
- Transmit accurate compensation data for each employee to your payroll processor and plan service provider
- Consider amending your plan to use one definition of compensation for all plan purposes
- Periodically review your plan for errors and fix them as quickly as possible using IRS correction programs
To download a copy of this article click here
IRS webpage, Avoiding Compensation Errors in Retirement Plans, https://www.irs.gov/retirement-plans/avoiding-compensation-errors-in-retirement-plans
Newport Group and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before making any decisions. 690123 (12/2018)