I have a 401(k) Plan but Contributions Keep Getting Returned to Me. Why?
Sound familiar? The plan may not be designed as efficiently as possible if it is failing the ADP, or Average Deferral Percentage test. In fact, more than 57,000 401(k) plans failed recent nondiscrimination tests, according to research by retirement plan data publisher Judy Diamond Associates (JDA).
Regulations require a plan to measure the salary deferrals made by highly compensated employees (“HCE”) against the salary deferrals made by non highly compensated employees (“NHCE”). HCEs are defined as employees making more than $115,000 last year, (2013) those that own more than 5 percent of the business sponsoring the plan in the current or last year or, by rules of attribution, spouses and lineal descendants and ascendants of owners of the business. If on average the HCE’s contribute more than 2 percent of the average contributed by the NHCEs, you have a failed test and plans are required to return some of the deferral contributions to the Highly Compensated Employees. Of course, after those monies are returned they become taxable as ordinary income. This process is known as a “corrective distribution.”
In fact, JDA found 57,277 401(k) plans failed their most recent nondiscrimination tests.
Monies being returned means the plan is not being maximized, not reaching its potential. One can have $52,000 added to their account in the 2014 year ($57,500 if age 50 or older) and not achieving this limit means less monies set aside for the future, more income taxes paid now, and less assets growing on a tax-deferred, asset protected basis. It also means perhaps the employees are unaware of all the plan has to offer. None of that is good!
For 2012, the most recent year data is available, $794 million in contributions were returned to HCE’s. Another way to look at it: 12 percent of 401(k) plans issued corrective distributions according to JDA. That is surprisingly large!
Corrective Distributions for 2012
States With Most and Least Corrective Distributions
% of plans
% of plans
Corrective distributions are administratively burdensome to sponsoring employers and the plan administrators, not to mention confusing and frustrating to the HCE’s. These corrective distributions mean some or all HCE’s were not able to defer as much of their taxable income as hoped.
Furthermore, research performed by IRS suggests corrective distributions tend to indicate systemic issues with a plan’s design.
What does that really mean? That plans are, in many instances, not designed to their fullest potential, not maximized to help the HCE’s, not doing what is available under the law to create the best Plan design for all participating employees. Surprisingly, just a few minor design changes can make a significant difference.
It doesn’t cost any more to do it right!
We’ve found the trouble often comes from the fact that many sponsoring businesses use the “cookie cutter” or “one-size-fits-all” design available from many payroll companies and mutual fund companies. And, boy, have some payroll companies and mutual fund companies done a great job making everyone think all 401(k) plans are the same. They are not all the same!
A custom-design frequently is the approach that will fix most plans. Simple changes like using the proper “safe harbor” contribution (did you know there was more than one way to do safe harbor?), the proper allocation of the profit-sharing contribution, using integration or not, automatic enrollment, and many other techniques too many to name here can all have a positive effect on the plan’s health and the sponsoring business’s tax benefits derived from the plan itself.
April 30, 2016 is the deadline for all defined contribution plans to be amended and restated, in their entirety, to comply with the Pension Protection Act (PPA). Now is the time to take a look at the whole picture. Much like we are not using the same cell phone we used 10 years ago, why think the plan that was implemented some time ago continues to be the most efficient design?
When amending for PPA take the time to look at the existing plan’s method of allocating the safe harbor contribution and the discretionary profit sharing contribution. Is it as effective as possible? Is it a matching safe harbor or non-elective? If no safe harbor, why not consider one? Is the plan top-heavy? Is there a consistent profit sharing contribution and, if so, is the contribution the same for all participants across the board or is the plan using “permitted disparity?” Are all the highly compensated employees deferring, and if not, why not?
Ask this question: “What is the goal with this plan?” Is it simply to make salary deferrals available to all employees, or is there something more that is sought? Used properly, the sponsoring company can obtain strong income tax deductions, tax deferred accumulation, and other features and all for little additional costs in administration or contribution allocations.
Some surprising deficiencies we’ve seen in plans brought to us for review is the prior prior administrator expected the client to prepare and distribute the annual safe harbor notice, prepare their own Form 5500, and the most shocking? Telling the client it is the client’s responsibility to allocate contributions! Wow. Talk about a recipe for disaster!
These plan are complex, the rules are complex, and administrative duties are time consuming. Thinking the sponsoring client is going to do all the above timely and accurately is unrealistic. In particular, when one considers how truly inexpensive the charges of a competent third party administrator (TPA) can be, there is no reason not to hire a competent TPA firm.
This discussion is not intended as tax advice. The determination of how the tax laws affect a taxpayer is dependent on the taxpayer’s particular situation. A taxpayer may be affected by exceptions to the general rules and by other laws not discussed here. Taxpayers are encouraged to seek help from a competent tax professional for advice about the proper application of the laws to their situation
AXA Advisors, its affiliates and its financial professionals do not offer tax or legal advice. Consult with your professional tax and legal advisors regarding your particular circumstances.
Bill H. Black, Jr. has been in the pension administration business for 34 years. The firm Pension Services, Inc. administers both defined contribution and defined benefit plans, employs an ERISA attorney, an Enrolled Actuary, and complete clerical staff. Bill is qualified to give continuing education to CPA’s in 47 different states. He has spoken nationally and internationally on retirement plans, has been quoted in USA Today, written articles for several industry journals and has appeared on many financial radio shows discussing the topic of retirement and financial matters. He is a much sought after speaker and author. He may be contacted at email@example.com.