Did you know that failed nondiscrimination tests can require costly corrections for plan sponsors? What are the implications of these 401(k) testing corrections on the company for the present and future? Learn more about how your plans should go about remediating 401(k) testing failures.

Nondiscrimination Testing Background

The Internal Revenue Code (the “Code”) requires qualified retirement plans to satisfy various compliance tests on an annual basis in order to ensure that plans are providing benefits to all employees and not disproportionately benefitting highly-compensated employees (“HCEs”). The tests compare the benefits received by highly and non-highly compensated employees (“NHCEs”) and each test limits the acceptable discrepancy between HCE and NHCE benefits. In the event that a plan fails annual compliance testing, there are various ways of correcting these testing failures.

Two of the most common annual 401(k) plan nondiscrimination tests are the Actual Deferral Percentage (“ADP”) and Actual Contribution Percentage (“ACP”) tests. The ADP test compares average rate of employee deferrals (pre-tax and Roth) as a percentage of compensation for HCEs to that of NHCEs while the ACP test is similar but compares employer matching contributions and after-tax contributions (if any) instead of employee deferrals. Both tests are passed only if the average HCE rate exceeds the average NHCE rate by no more than a specific threshold set forth in the Code. The rules for performing these tests are complicated and likely involve assistance from the plan’s recordkeeper or other testing experts.

Correcting Failed ADP-ACP Tests

The Code provides several potential options for correcting failed nondiscrimination tests, though plan sponsors may not find all of them to be practical depending on their specific situation. One of the most common methods for correcting a failed ADP or ACP test is to remove HCE contributions in order to lower the average contribution down to an acceptable level. To correct a failed ADP test, deferrals are refunded to HCEs, increasing their taxable compensation for the year in which the distribution is received. If any matching contributions were made on account of the refunded deferrals, they are required to be forfeited. Similarly, to correct a failed ACP test, excess vested matching contributions and after-tax contributions are refunded to employees, and non-vested matching contributions are forfeited.

Another method for correcting these failures is to make qualified nonelective employer contributions (“QNECs”) to NHCEs to bring their contribution rates up to the minimum percentage required to pass the test. This correction method allows HCEs to retain their contributions but can be expensive depending on the NHCE population receiving the QNECs.

Plan sponsors should consider several factors when deciding how to correct 401(k) testing failures including the magnitude of the failure, the size of the employee population, the amount of contributions or refunds at issue, concerns about employee perception (particularly related to refunds or forfeitures, which may be more likely to impact executives), and the timing of the correction.

Other Considerations

There are other obstacles to consider when having to make corrections, including deadlines and penalties. For example, most plan sponsors are required to pay a 10% excise tax on the total amount of refunds or forfeitures if corrections are made later than 2 ½ months after the end of the plan year being tested (i.e., March 15th for a calendar year plan). If corrections are made later than 12 months after the end of the plan year being tested (i.e., December 31, 2021 for 2020 testing for a calendar year plan), this constitutes a qualification failure. In this situation, the plan sponsor must correct the failure based on the IRS’ guidance in the IRS Employee Plans Compliance Resolution System (EPCRS). The plan sponsor has two options under EPCRS: 1) make QNECs as described above or 2) utilize the one to one correction methodology. Under the QNEC method, the plan sponsor would undertake the same actions described above, which can be very expensive.  Alternatively, under the one to one method, amounts are distributed to HCEs using the methodology described above but an additional contribution equal to the distribution amount is required to be made and allocated to certain NHCEs. The plan sponsor must also pay the 10% excise tax on the total amount of refunds or forfeitures to HCEs.

Corrections for failed nondiscrimination tests can have impacts far beyond the financial statements for a given plan year. Failures in a plan that has generally passed nondiscrimination testing in previous years can be the result of M&A activity or other shifts in the employee population, and repeated failures may indicate that a plan design change is necessary to ensure that the plan continues to meet the goals of the plan sponsor. 

The professionals at Alvarez & Marsal Taxand, LLC are uniquely qualified to assist you with all of your compliance filing needs related to 401(k) testing and distributions. If you have any questions please contact our dedicated qualified plan team.