Why Am I Getting Refunds From My 401(k)?

Normally, the word “refund” sparks visions of putting a hefty tax return toward a big-ticket item you’ve had your eye on or getting a little extra cash to pad your day-to-day budget.   

But if you are an executive or business owner, “refund” can oftentimes bring up a different type of feeling, especially when it comes to the retirement plan you run for the company.  

If your plan participants have received refunds or corrective distributions from your 401(k), it can be a frustrating experience and a sign something wasn’t set up correctly.   

Here’s what it means: what your key employees thought were pre-tax savings into their retirement accounts are now considered excess contributions, which in turn becomes taxable income when the refund check comes in.  

So why are you getting refunds and is there anything you can do about it?  

Why Am I Getting Refunds?  

The most common reason for 401(k) refunds of excess contributions is because the plan sponsor has failed the ADP test.  

ADP stands for Actual Deferral Percentage. When ADP test failures occur, elective deferrals that employees set aside for in retirement accounts have to be returned to them. 

What is the ADP Test?  

The ADP test compares the average savings rate of your Highly Compensated Employees (HCEs) to the average savings rate of your Non-Highly Compensated Employees (NHCEs).  

HCE and NHCE are defined by the IRS.  

The purpose of the ADP test is to assure that all eligible employees, regardless of compensation level, are benefitting from the company’s retirement plan.  

What are HCEs & NHCEs?  

A person can be designated as a Highly Compensated Employee for a few reasons:  

• If they earned more than $150,000 in 2023, they would be considered an HCE in 2024, regardless of their current year income. The IRS adjusts this income threshold yearly, as with contributions limits, but it is based on the prior year earnings.  
• If someone owns more than 5% of the business, regardless of their income, they would be considered an HCE.   
• Employees who are related to owners may be included as HCEs because of familial ownership – even if that person does not own the business at all directly.   

Any employee who doesn’t meet the above criteria is considered an NHCE. If you’re curious about whether the definitions are what’s causing the test failure, reaching out to your plan sponsor or someone like Plancorp who has a dedicated ERISA team is a great idea.  

How Does the ADP Test Work?  

HCEs savings rates are limited, on average, to a rate that is more than the average savings rate of the NHCEs based on the formula below. 

A few examples:  

• If the NHCE average savings rate is 1.5%, the HCE average is limited to 3% (1.5% X 2)  

• If the NHCE average savings rate is 6%, the HCE average is limited to 8% (6% + 2%)  
• If the NHCE average savings rate is 9%, the HCE average is limited to 11.25% (9% X 1.25)  

The 20% Rule  

There is an exception to this called the “20% Rule.” The 20% rule limits HCEs for testing to only the top 20% of earners, even if more than that qualify based on income. You see this often in places like New York City and California, and especially at organizations like a law firm. 

What Happens if HCEs Save More Than Allowed?  

Following the end of the plan year (most plan years match the calendar year and end on December 31), HCEs may receive a refund. This is an effort to lower the HCE average based on the formulas above.   

Instead of being considered money deferred into a retirement plan, refunded money is considered income as if they had never saved it into the 401(k).  

At that point, the employee will owe income tax, which can be an unwelcome situation for those who thoughtfully plan and run a tax projection for the year.  

What Can I Do to Improve the ADP Test?  

There are two options to improve the results of your ADP test.  

Use a Safe Harbor Contribution  

Employers can contribute to the retirement plan with a Safe Harbor Non-Elective or Safe Harbor Match formula.   

A Safe Harbor plan allows a company to automatically pass the ADP test. At that point, all employees, including HCEs, savings would only be limited by IRS guidelines.   

For 2024, that is $23,000 for people under age 50 and $30,500 for people 50 and older.  

Increase NHCE Plan Participants and Savings Rates 

Longer term, a solution should focus on increasing participation rates and savings rates of NHCEs. Some specific improvements can help increase NHCE interest and average savings rate in the 401(k):  

• Decreasing plan costs  

• Improving investment options  

• Having hands-on enrollment sessions with the help of an advisor  

• Offering education for eligible employees on the benefits of tax-advantaged retirement savings explaining any employer contributions or matching contributions, outlining 401(k)s, Roth IRAs, and other after-tax retirement options to ensure a secure retirement.  

Next Steps  

If you are having trouble with HCEs receiving refunds in your company, the first thing to know is that this is incredibly common for small business 401(k) plans.  

Having a trusted advisor on your side is a great solution to make sure you are making the most of your retirement plan, increasing participation, and avoiding IRS pitfalls like the ADP test. A professional can help you set up a multi-faceted retirement system that works at all levels of your company to properly incentivize employees and maximize retirement savings.  

We help hundreds of clients each year with problems just like this, and are happy to offer a free, no-obligation appraisal of your current plan to see where we could offer improvements and give you confidence in your retirement offerings.   

Ready to get started? Reach out now to start your appraisal.