Corrective distributions occur when a 401(k) plan sponsor has to return a portion of the contributions made by highly compensated employees (HCEs). Corrective distributions arise out of the plan’s failure to pass its annual non-discrimination testing. These corrective distributions are not a welcome occurrence by the HCEs receiving them. Beyond this, they are also indicative of a bigger problem, mainly under participation by the lower compensated employees, which should be a far bigger concern for plan sponsors.
Types of non-discrimination tests
There are two annual non-discrimination tests required:
- The ADP (Actual Deferral Percentage) test compares the average salary deferral percentages for HCEs to those of NHCEs (non-highly compensated employees). If the percentage of deferrals for HCEs exceeds the average for NHCEs by more than a specified amount, then the plan must take corrective action which can include corrective distributions.
- The ACP (Actual Contribution Percentage) is similar to the ADP test, but includes employer matching contributions and after-tax contributions to the plan.
There are several corrective actions that a plan sponsor may need to take if they fail one or both tests. Corrective distributions are one such corrective action and need to be completed within a set timeframe after the end of the plan year.
Definition of HCE
The annual income level to be considered a highly compensated employee remains unchanged in 2021 at $130,000.
Taxes on corrective distributions
Corrective distributions are taxable to the employees receiving them, except for any designated Roth 401(k) contributions included in the distributions.
These distributions or any other corrective actions must take place within two-and-a-half months of the end of the plan year per the IRS to avoid a 10% excise tax.
The employees receiving these distributions may be angry and frustrated at receiving these distributions due to the taxes that may be due and the reduction in their retirement savings.
Reviewing your plan
If your plan is continually having to issue corrective distributions to HCEs or take other corrective measures each year it is important to review your plan and consider actions to correct the issues that are keeping your plan from passing the annual testing.
As a first step you may want to ask your plan consultant to do a mid-year compliance test to see how your plan is tracking against the required deferral and contribution levels for the ADP and ACP tests. This certainly isn’t anything official, but it can help highlight weak spots.
Beyond the fact that your HCEs don’t want to be receiving these corrective distributions, the fact that your plan is forced to issue them for failing its discrimination testing is a red flag that there are issues with your plan. Here are some options to consider.
Safe Harbor plans
You might consider moving to a Safe Harbor arrangement for the plan. Safe Harbor plans exempt the plan from testing requirements for the ADP, ACP and top-heavy tests. In cases where there is a Safe Harbor match, this forces participants to contribute enough to earn some or all of the match. This could potentially increase the amount they contribute.
There are two options for a Safe Harbor qualification. The basic Safe Harbor match is 100% on the first 3% contributed and 50% of the next 2% of salary contributed to the plan. The enhanced match is 100% on at least the first 4% of their contributions, up to a maximum of 100% of the first 6%.
In plans where the employer chooses the non-elective contribution route, this provides an employer profit-sharing contribution of at least 3% to all employees regardless of whether they contribute their own money.
A Safe Harbor plan will allow the company’s HCEs to contribute the full amount to the plan without having to worry about the plan passing discrimination tests. It can also provide a means to increase the amounts NHCEs contribute via the matches, or it can ensure that each employee receives something if the non-elective route is chosen.
Employers will need to look at the costs of the matching or non-elective contributions to determine if this expense is worthwhile. HCEs are often major players and an important part of the company, so giving them the ability to contribute the maximum amount for retirement may be worth it based on that alone.
Initiating an auto enrollment program for your plan might be a good solution to the underlying issues causing the inability to pass the discrimination tests. Auto enrollment will start contributions for every employee into the plan, except those who choose to opt-out. As the plan sponsor, you have the choice to set the initial contribution rate. If you set the initial contribution higher than the typical 1% – 2%, perhaps in the 4% – 6% range, you will go a long way towards solving your plan’s testing issues.
More important, by setting the auto enrollment percentage a bit higher, you are helping to solve the problem that many Americans are facing, which is not saving enough for retirement.
Employee financial education programs can be helpful to your participants about how much they may need to contribute, and why starting now is so important to achieve a comfortable retirement.
There are a number of different types of approaches and programs that plan sponsors can consider, but the bottom line is that they all can help motivate employees to participate in the plan and perhaps increase the amount they contribute.
Corrective distributions are a symptom of a problem with a 401(k) plan. Plan sponsors need to understand that the issue is that NHCEs are not contributing enough, or they are not receiving an acceptable percentage of any employer contributions. Helping to rectify this situation is generally the best approach for a plan sponsor to take in response to corrective distributions.
Shelton Capital Management does not provide accounting or tax advice to its clients. All clients should be aware that tax treatment is subject to change by law, in the future or retroactively, and clients should consult with their tax advisors regarding any potential strategy, investment or transaction.
The information provided should not be considered investment advice and does not provide information reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell any particular security.