When an employee contributes too much to a 401(k) plan, a common fix is for the excess amount to be refunded to the employee. The technical term for this kind of refund is “corrective distribution.” At this time of year, plan sponsors may be scrambling to get refunds processed by March 15 in order to avoid penalty taxes.
What does “contributing too much” to a 401(k) plan mean? It could mean that the dollar limit on deferrals was exceeded. The most an individual may defer into a 401(k) plan in 2018 is $18,500. The limit in 2017 was $18,000. In both years, an additional “catchup contribution” of $6,000 is permitted for employees age 50 or over. The amount an employee defers that exceeds this dollar limit is called an “excess deferral.”
There is also something called an “excess contribution” which, despite the similar name, means something completely different. An excess contribution occurs when a plan fails the ADP test. This article gives a brief overview of excess deferrals and excess contributions and how to correct both with refunds.
Excess Deferral Means Contributing More than the Dollar Limit
The limit on salary deferrals is $18,500 per employee, per tax year. The tax year for an individual is almost always the calendar year. There is not a separate $18,500 limit for each plan the employee participates in. Rather, an employee gets a single $18,500 limit to use in one plan or to spread out among all the 401(k) plans the employee is in.
Excess deferrals often occur when an employee works at more than one place in a year. Being unfamiliar with the rules, an employee might defer $10,000 into the 401(k) at one company, then switch jobs and defer another $10,000. For that matter, the same thing could happen if the employee works at two places at once. Neither company has any way of knowing what the employee contributed at his other job. It is up to the employee to notify one company or the other (or both) of an excess deferral and the desire to correct it. Neither employer has any responsibility in this matter if the employers are not affiliated.
If the employee worked at only one place during the year and there was an excess deferral, it means someone was asleep at the switch. Most payroll systems should cut an employee’s deferrals off when the limit is reached. If a payroll system is not being used, as is often the case for self-employed individuals, there is a greater risk of excess deferrals.
The employee should notify a plan no later than March 1 following the calendar year for which the excess deferral was made. Withdrawal of the excess deferral must be made by April 15. The distribution must include earnings (either positive or negative). If the withdrawal is not made timely, the excess deferrals will be taxed twice – once in the year made and again in the year distributed.
The tax reporting for an excess deferral can be rather thorny. The employee’s Form W-2 should include the entire amount of elective deferrals, even the excess. The corrective distribution is reported on a Form 1099-R, not on the W-2.
If the corrective distribution for an excess deferral occurring in 2017 is taking place in 2018, two separate Forms 1099-R are issued. One 1099 reports the excess deferrals with Code P, indicating this part of the distribution is taxable in 2017. The other 1099 reports the allocable earnings with Code 8, meaning this part of the distribution is taxable in 2018. Note that there are two 2018 1099s that would be issued, one for the excess deferral and the other for the earnings, even though the excess deferral itself is taxable in 2017. Had the correction been made in 2017, one 2017 Form 1099-R would have been issued, with the entire distribution taxable in 2017.
Excess deferrals for Highly Compensated Employees are counted in the ADP test. Excess deferrals for Non-Highly Compensated Employees are not counted in the ADP test.
A refund of an excess deferral that is a designated Roth contribution is not taxable since Roth contributions are made on an after-tax basis. The earnings distributed are taxable since this is not a qualified distribution. If an excess deferral is not distributed timely, a designated Roth contribution could be taxed when it is ultimately distributed.
Failed ADP Tests Give Rise to Excess Contributions
An excess contribution occurs when the ADP test fails. Consider a plan under which the ADP for NHCEs is 6.00%. To pass the ADP test, the ADP for Highly Compensated Employees may be no more than two percentage points greater than the NHCE ADP, or 8.00%. Suppose the ADP for a plan with two HCEs is 10.00%, as follows:
|Sum of ADRs||20.00%|
|Number of employees||2|
|ADP (ADRs ÷ # of EEs)||10.00%|
In the olden days (before 1997), assuming the employer wished to correct the ADP failure by issuing a refund, Baker would have been the one to get the refund because his ADR is higher. A refund of $6,000 to Baker would bring his ADR down to 8.00% ($12,000 ÷ $150,000), so the HCE ADP would be 8.00% and the test would pass.
Somewhere along the line, it was decided that it wasn’t fair for the lower-paid HCE to bear the brunt of the refunds like that. Why not let the higher-paid HCE share in the refund fun? And so the law was changed. Now the refund amounts are determined in two steps. The first step is similar to the example above. Find the excess contribution amount that would reduce the highest HCE’s ADR down to the next highest HCE’s ADR. Next, find the additional excess contribution amounts that would reduce the highest two ADRs down to the next highest, then the highest three down to the next highest, and so on. You stop when the HCE ADP generated in this manner would produce a passing ADP test.
What is different under the “new” 1997 law is that you do not simply refund to each HCE the excess contribution attributable to that HCE. Rather, you add up all HCEs’ excess contributions to arrive at a total for the plan. You then reduce the deferrals of the HCE with the highest dollar deferral, not the highest ADR, so that he is now tied with the HCE with the next highest dollar amount. Next, you reduce the deferrals of those highest two HCEs down to the next highest, then you reduce the three highest, and so on. You stop when the total excess contributions have been apportioned to HCEs. These are the tentative refund amounts.
In our example above, Adams and Baker deferred the same dollar amount ($18,000). Therefore, they will each be refunded $3,000 of the $6,000 total excess contributions (all of which had been attributable to Baker in Step 1). Suppose in another plan Charles had deferred $18,000, Davis had deferred $14,000, and there was $6,000 total to be refunded. Charles would receive a refund of $5,000 and Davis would receive $1,000 so that the deferrals for both would end up at $13,000.
Other comments about correcting a failed ADP test are as follows:
- Should you try to rerun the ADP test after apportioning the excess contributions among HCEs, you will find that the test does not pass. This is perfectly normal and is to be expected.
- If an employee age 50+ has not already made $6,000 in catchup contributions, the amount owed as a refund may be treated as a catchup contribution, eliminating the need for a physical refund.
- In addition to the excess contribution itself, earnings on the excess contribution must be refunded.
- There are other ways to correct a failed ADP test, such as with QNECs or QMACs, that are beyond the scope of this article.
Timing and Taxation of ADP Refunds
Refunds of excess contributions plus income must be made to HCEs within 12 months after the close of the plan year in which the excess contribution arose. However, if the refund is made more than two-and-a-half months after the close of the plan year, a 10% excise tax is levied on the employer (not the HCE). This is why March 15 is such an important date for 401(k) refunds. For a calendar year plan, this is the date after which a 10% excise tax would apply on a refund.
Unlike an excess deferral, excess contribution refunds must be made after the plan year has concluded. If an employer realizes during the plan year that an ADP test failure is likely and decides to issue a refund before the plan year is over, it would need to do another refund after the plan year has ended, as the one during the plan year is not an allowable fix for an ADP failure.
The corrective distribution is included in the employee’s income in the year the refund was issued. As a result, the entire distribution (excess contribution plus earnings) may be reported on a single 1099 with Code 8. It used to be that the refund was taxable for the year the excess contribution was made, making completion of the personal tax return awkward for the employee.
As with excess deferrals, a refund of an excess contribution that is a designated Roth contribution is not taxable since Roth contributions are made on an after-tax basis. The earnings distributed are taxable since this is not a qualified distribution.