Thousands of 401(k) plans failed their recent IRS nondiscrimination testing and had to return excess contributions to highly compensated employees because of imbalanced retirement plan coverage, according to research by a 401(k) advisory firm.
Almost 60,000, or about 12 percent, of plans reviewed were forced to make “corrective distributions” to HCEs in 2012, the latest available data from the U.S. Department of Labor, Judy Diamond Associates’ research concluded. The paybacks, which can be taxed as regular income by the federal government, totaled $794 million, the plan adviser said. The portion of plans with corrective distributions in 2012 was down 2 percentage points from the previous year.
Nondiscrimination testing may be the administrative bane of every retirement plan sponsor, yet passing a nondiscrimination test is necessary to obtain the tax advantages associated with being a qualified plan.
Different Kinds of Tests
Nondiscrimination tests involve dividing a workforce into groups of high-paid employees and low-paid employees. This process varies with the type of benefit being tested. Some tests focus on HCEs, while others focus on “key employees,” “highly compensated individuals” or “control employees.” Some of the tests require leased employees to be counted as employees for testing purposes; others do not. And finally, the rules are not uniform, nor do they provide clear guidance on how the tests should be applied to former employees, employees of related corporations or individuals who are employed in separate lines of business, according to Thompson Information Services’ The 401(k) Handbook.
Specifically, to obtain the tax advantages associated with being a qualified plan, a 401(k) plan must cover a nondiscriminatory group of employees under the provisions of Code Section 410(b). In addition, contributions or benefits under the plan may not discriminate in favor of highly compensated employees under the provisions of Code Section 401(a)(4). In general, these requirements mean that a qualified plan may not provide higher-paid employees with a “better deal” than the plan provides rank-and-file employees.
Having to make corrective distributions can indicate that “a plan is not designed to encourage workers to contribute sufficiently,” Eric Ryles, managing director of Judy Diamond Associates, said.
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