While failure is something that most people avoid at all costs, it’s actually very common among 401(k) plans. One study found that over 57,000 plans had recently failed their most recent nondiscrimination testing. (1) As a result, those companies had to return $794 million in contributions to their highly compensated employees. When that happens, the highly compensated employees not only get behind on their retirement savings, but they end up with a higher tax bill as well.
It’s important for you, as their financial advisor, to understand the consequences of failing nondiscrimination testing for your business owner clients. In addition to getting frustrated and perhaps a little embarrassed, the following is what will need to happen:
Correcting An Actual Deferral Percentage Or Average Contribution Percentage Test Failure
If your client’s 401(k) plan fails either of the ADP or ACP tests, they will need to fix it. A testing failure means that the percentages are off between the highly compensated employees’ (HCE) contributions and the non-highly compensated employees’ (NHCE). To correct, either the HCE contributions must be decreased or the NHCE contributions must be increased.
This can be done by returning the HCE’s contributions as discussed above, which raises their income tax bills and derails their retirement savings. Or the company can make contributions to the NHCE’s accounts, which costs the company money, though they are tax-deductible.
Correcting A Top-Heavy Test Failure
Failing the top-heavy test means that the company’s key employees own more than 60% of the plan assets. Correcting such a failure is done by contributing to the non-key employees’ accounts, up to 3% of compensation (as per IRS regulations). Unlike with the ADP and ACP tests, refunding the key employees’ contributions is not an option.
Penalties And Deadlines
Failure to pass a nondiscrimination test in and of itself will not result in penalties. Failure to make corrections in a timely manner is what really gets plans into trouble. The deadline for making corrections is March 15. If corrections are not made by that deadline, your client will have to file Form 5330 and pay a 10% excise tax.
Your client has 12 months to make any necessary corrections on their own. If they fail to do so within that time period, they will have to use the IRS’s Self-Correction Program (SCP) or Voluntary Correction Program (VCP) to rectify the situation. After two years, the SCP can only be used to correct insignificant mistakes. Any significant mistakes will have to be corrected through the VCP, though that program can also be used for insignificant errors as well. By the time they reach that point, the plan is at risk of losing its qualified status, meaning both the employer and employees would have to pay taxes on all contributions made.
How To Prevent A Nondiscrimination Testing Failure
As we near the end of the year, now is the time to do an assessment of your clients’ 401(k) plans to see if preventative measures need to be taken to maintain compliance. To do so, simply calculate the contribution percentages of HCEs and see how they compare to the NHCEs. If things are close, your client may want to ask their HCEs to refrain from contributing or take steps to encourage the NHCEs to contribute more.
If your clients need help calculating how their 401(k) contributions are going for the year, or if they have failed testing and need help correcting their mistakes, I can help. Email me today at email@example.com.
About Kenny Phan
Kenny Phan is a Managing Partner at FinancialFocus Retirement Plan Services, a 3(16) fiduciary. He works as a pension specialist who partners with financial professionals to design and implement pension plans. His area of expertise is customized defined benefit, defined contribution, and 401(k) plans. Serving financial advisors and businesses in the greater Phoenix area, he is supported by FinancialFocus Retirement Plan Services. Together, they provide comprehensive plan design consultation, administration, document installation, compliance testing, as well as IRS and DOL reporting for qualified retirement plans.