SITUATION: When we conducted our annual nondiscrimination testing, we found that several of our highly compensated employees had contributed disproportionately more to our 401(k) plan than lower paid employees. Our plan failed the “actual deferral percentage” (ADP) test for the ﬁrst time.
QUESTION: What do we need to do?
ANSWER: To avoid possible plan disqualiﬁcation, you need to correct the excess contributions.
DISCUSSION: The ADP test compares the average rate at which highly compensated employees defer salary with the average deferral rate for nonhighly compensated employees. The diﬀerence between highly paid and lower paid employees must be within certain limits. If it isn’t, you need to correct the excess contributions. You basically have three options.
Distribution option. The plan can return the excess contributions and any plan income attributable to those contributions to the appropriate highly compensated employees within 12 months of the close of the plan year. However, if the distributions are returned more than 2½ months following the close of the plan year, the employer is subject to a 10% excise tax. For plans that are “eligible automatic contribution arrangements,” corrective distributions can be made up to six months following the end of the plan year without incurring the excise tax. The distributions are taxable to the employees.
Recharacterization option. Alternatively, the plan can recharacterize the excess contributions as after-tax contributions. To do so, your plan must have a provision allowing such contributions, and the recharacterization must occur no later than 2½ months after plan year-end. Amounts recharacterized as after-tax contributions are includable in the highly compensated employees’ income for federal income-tax purposes.
Or instead, if the plan allows, an excess contribution made by an employee who is age 50 or older may be treated as a catch-up contribution to the extent the employee hasn’t already made the maximum allowable catch-up contribution for the year.
Additional contributions option. Another alternative is to make qualiﬁed nonelective contributions
(QNECs) or qualiﬁed matching contributions (QMACs) for nonhighly compensated employees. Such contributions will be treated as elective contributions for ADP testing purposes.