Getting a refund typically means receiving a welcome windfall. Not so when it comes to 401(k) refunds, also known as corrective distributions.
Corrective distributions are troublesome for both employers and employees. If it becomes necessary for an employer to issue a 401(k) refund, that means the 401(k) plan has failed annual nondiscrimination testing. It also means returning to highly compensated employees (HCEs) tax-deferred money that they have earmarked for retirement. Processing these refunds is both costly and time-consuming for plan sponsors. In addition, affected participants must be notified of the error, which means managing potentially unhappy employees who are now forced to deal with expected taxable income that they hadn’t planned on.
Plan sponsors are required to perform nondiscrimination tests each year to ensure their 401(k) plan does not favor HCEs (5% or more owners of the company, a direct family member of an owner, or earn more than $130,000 per year).
However, if the plan fails nondiscrimination testing, it may become necessary for the plan sponsor to refund excess 401(k) contributions to HCEs. This creates unplanned taxable income for the current tax year, potentally pushing HCEs into a higher tax bracket. It also reduces pre-tax savings benefits, and can result in lost opportunities for these employees to receive and maximize the company match. Yet another downside: Having to refund 401(k) contributions also exposes employers to potential risks, including hefty fines and a loss of qualified plan status.
A Simple Fix
There is a simple solution: Leveraging the built-in flexibility of non-qualified deferred compensation (NQDC) plan design can help combat these complexities. Excess 401(k) contributions can be included as a deferral source and election in the NQDC plan design. Essentially, this allows participants the opportunity to elect to defer a portion of their base salary equal to the potential 401(k) refund on a pre-tax basis while taking advantage of tax deferrals on investment gains.
If elected before the calendar year begins, it creates a tax-neutral event for the year in which the refund occurs. It’s a simple as checking a box, and the employer and employee won’t need to face penalties for excess 401(k) contributions.
If your organization currently offers an NQDC plan, you can add this feature or take advantage of other custom NQDC plan designs that help solve for discrimination testing challenges. If you don’t offer an NQDC plan, we can help you establish one that is structured to optimize pre-tax deferral opportunities for your most valued employees.