The 401(k) Excess Contribution Solution
To help ensure that a 401(k) plan does not favor business owners or other highly compensated employees (HCEs), plan sponsors are required to perform specific nondiscrimination tests. The Actual Deferral Percentage test (ADP) is used to help determine a 401(k) plan’s deferral limits.
IRC Section 401(k)(3)(A)(ii) established the ADP test to compare a plan’s average deferral percentage by HCEs to the average deferral percentage of non-highly compensated employees (NHCEs). How successfully a plan passes this test, however, may not be known until the end of each year.
If the deferrals of HCEs are too high relative to the deferrals of NHCEs, some of the HCEs may have a portion of their deferrals refunded to them in the next tax year. This is known as an excess contribution or a 401(k) refund.
A 401(k) refund immediately becomes unplanned taxable income for the employees, and potentially a lost opportunity to collect company matching dollars for 401(k) savings. Additionally, the employer is at risk of fines and/or potentially losing qualified plan status.
Nonqualified deferred compensation plans (NQDC) can be designed to allow plan participants to defer an amount of their base salary equal to the refund, to create a tax neutral event for the year in which the refund occurs. These deferrals are sometimes called “401(k) refund deferrals” or “401(k) offsets.” if your firm offers a NQDC plan currently, this feature can be added. If your firm does not offer a NQDC plan, contact the team at Fulcrum Partners, LLC.
Creating a tax neutral event requires the following:
- In the first year, the participant defers money into his/her 401(k) plan on a pretax basis. Also, during that year, the participant must make a deferral election to defer into the nonqualified deferred compensation plan in the next tax year (if a refund occurs), base salary in an amount equal to his 401(k) refund.*
- In the second year, if a 401(k) refund occurs, the participant is taxed on his 401(k) refund.
- Also in that year, the participant defers base salary equal to the 401(k) refund amount into a nonqualified deferred compensation plan.
- The final tax event occurs when the participant has a distribution from his nonqualified deferred compensation plan in which the amount of that deferral, plus earnings, is distributed.
Commit before the start of each calendar year to use a NQDC to create a tax neutral event for HCEs in case your plan is found to include 401(k) excess contributions. It’s a simple “check-the-box” solution for employees and employers that helps assure there will be no penalties or problems from excess 401(k) contributions.
In 2019 a participant defers $10,000 to his/her 401(k) plan. Prior to December 31, 2019 the participant makes an irrevocable election to defer an amount of base salary equal to 100% of his 401(k) refund, if one occurs in 2020.
In 2020, nondiscrimination plan testing reveals that the participant must receive a 401(k) refund of $1,500. The $1,500 represents both participant deferred money and associated earnings. This refund is taxed in that year (2020) and reported on a 1099-R. Additionally, pre-tax deferral of $1,500 is made to the nonqualified deferred compensation plan in 2020. This creates a
tax neutral event for the 2020 tax year.
In 2023, the participant has a distribution event. This $1,500 is now worth $2,000 due to market growth. The $2,000 is taxed as ordinary income, with federal and state taxes withheld, and reported on a W2.
*Treas. Regs Section 1.409A-2(a)(3) Because the base salary deferred is earned in Year 2 the general timing rules of IRC 409A govern the timing of the deferral.
Fulcrum Partners advises you to always consult your own tax, legal, and accounting advisers.
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