After a plan year ends and all payrolls have been processed, 401(k) plans must be reviewed for compliance using several IRS-required limit and nondiscrimination tests. Additional employer contributions may also be required, depending on the plan document.
Each test and employer contribution has different deadlines and dependencies. If a test exceeds a limit or additional contribution is required, it must be corrected or completed, even if the adjustments should have occurred several years ago (there is a small exception for employee contribution limit failures due to external contributions).
If a test is corrected after its applicable deadline, additional taxation may apply. Additionally, if contributions are made after the sponsor’s taxes are filed, it could impact the following year’s limits tests.
While all tests and contributions should generally be corrected or contributed as soon as administratively feasible, ideally all should be completed by the end of the calendar year following the applicable plan year at the latest.
Note: If your plan is required to have an audit as part of the Form 5500 filing, your auditor will want to review all tests as part of the audit.
Compensation data and self-employed owners
In many cases, Guideline cannot complete your testing without complete and accurate compensation data. For plans taxed as a partnership or sole proprietorship, in particular, most year-end tests need complete and accurate compensation data from self-employed owners.
If compensation is not available through your payroll provider (including any self-employment income), Guideline must collect this data via a compensation task. Accurate compensation is crucial to ensuring contributions and tests are accurate. You can find out more about what to report for employee compensation and self-employed compensation.
Self-employed owners must first complete their taxes before they can report compensation. Compensation provided through the task must not be estimated. If partial or estimated compensation is reported for self-employed owners, testing will be inaccurate and the owner may not receive the full benefits they are entitled to for match, safe harbor non-elective contributions, and/or profit sharing allocations. If you have questions about what compensation to include, please use the articles linked above or contact our sponsor support team.
Limits testing
There are several limit tests that apply to 401(k) plans. The limits work differently depending on whether they include employee contributions only or include employer contributions as well.
Employee only limits
The IRS limits the amount of employee contributions that can be made in a calendar year. If any employees exceed these limits, Guideline typically handles the correction directly with those participants by April 15 of the year following the plan year when the excess occurred.
If participants made 401(k) contributions to accounts outside of Guideline, they are required to report them to us no later than March 1. If the excess is due to contributions to more than one unrelated plan and Guideline is not informed of the external contribution on time, Guideline is not permitted to distribute the excess after April 15 under IRS rules. If the excess is within one plan or within plans of a legally related group (LRG), Guideline must distribute the excess once detected, even if after April 15.
How excess deferrals are taxed depends on when the excess is refunded:
If the excess is refunded in the same year it was deferred, the excess and any applicable gains will be taxed as regular compensation in the year distributed.
If the excess is refunded after the end of the year but prior to the IRS tax deadline of April 15, the excess funds will be taxable in the calendar year deferred and earnings on the excess contribution (if applicable) will be taxed the year the refund is distributed.
If the excess is refunded after April 15 of the year following the excess deferral, the excess funds will be taxable in the calendar year deferred. In addition, the excess funds and earnings on the excess contribution (if applicable) will be taxed the year the refund is distributed.
Sponsors within an LRG at Guideline can help by ensuring that employees who are participating in more than one LRG member have their accounts linked and that final year-end payrolls are processed timely.
Employer limits
Either Guideline or your payroll provider will typically monitor for employer limits throughout the year and attempt to stop excess contributions from being contributed to the plan. However, due to the nature of payroll this process is never perfect. Here are a few examples scenarios where the limits can be exceeded and require correction after the end of the year:
Unexpected or unusual paychecks: The payroll provider or Guideline system may lower contributions based on expected compensation once a participant is approaching a limit. If there is a large bonus, commission, or other paycheck that exceeds normal amounts when a participant is approaching a limit, the contribution could take the participant over the applicable limit. Most commonly it would be the compensation limit that would be exceeded for unexpected paychecks.
Low self-employment compensation: Guideline allows self-employed owners to contribute to the 401(k) plan during the year through owner’s draws. If the business has an unexpected loss or lower-than-expected earnings, those contributions may end up exceeding the annual additions limit since contributions to the plan cannot exceed actual compensation earned for the plan year. This determination is dependent on the self-employed owner accurately completing the compensation task.
Other errors: Less common, there are other errors that could occur and may result in exceeding the compensation limit and/or annual additions limit. For example, Guideline monitors payroll for corrections but there are times that corrections are not picked up by integrations. In addition, if an employee participates in several Guideline plans but the plans are not properly or timely linked together, limits can be exceeded.
All employer contribution limits should be corrected as soon as administratively feasible after the end of the plan year. In general, there are no direct tax consequences to exceeding the compensation limit and/or annual additions limit. However, the IRS expects these limits to be closely monitored. Excesses should be rare. If there is a pattern of not timely correcting limits, the plan could be at risk for disqualification by the IRS.
Nondiscrimination testing (ADP/ACP and Top Heavy)
Safe harbor plans are not subject to ADP or ACP tests. Additionally, Safe harbor 401(k) plans are not subject to top-heavy minimum contributions as long as the only employer contributions made to the plan are the safe harbor contributions.
Non-safe harbor 401(k) plans are subject to both ADP and ACP testing if a discretionary match is made. In addition, non-safe harbor plans may require top-heavy minimum contributions, if applicable.
ADP and ACP corrections timing
ADP and ACP testing failures can be corrected by contributing additional qualified nonelective contributions (QNECs) to non-highly compensated employees (NHCEs) or by distributing excess elective deferrals to highly compensated employees (HCEs). The ADP and ACP tests require accurate compensation. If compensation is provided later in the year so that testing needs to be redone and fixes made, excise taxes could apply.
If a failure is corrected by distributing refunds: Refunds distributed after March 15 for an automatic contribution arrangement (ACA) plan or June 30 for an eligible automatic contribution arrangement (EACA) or qualified automatic contribution arrangement (QACA) plan are subject to a 10% excise tax. (You can learn more about ACA, EACA, and QACA plan designations here.)
If a failure is corrected by contributing QNECs: Sponsors should contribute any QNECs before their tax-filing deadline so that the contributions can be deducted from employer taxes.
Top-heavy corrections timing
A plan that is top heavy must contribute top-heavy minimum contributions (THMC) to certain non-key employees. While top-heavy status does not depend on compensation, the THMC does (THMCs are a percentage of compensation, up to 3%), so this cannot be processed without accurate compensation data.
Sponsors should contribute THMCs before their tax filing deadline so that the contributions can be deducted from employer taxes.
Profit sharing, true ups, and other year-end employer contributions
Like numerous processes above, Guideline cannot calculate profit sharing, true ups, and other year-end contributions without accurate compensation data. Most of these contributions are based on a percentage of compensation or need to consider compensation to ensure the annual additions limit is not exceeded.
Employer contributions are generally tax deductible and certain plans can receive a tax credit for employer contributions. In order to deduct or receive a credit for the expense, it must be contributed to the plan before the sponsor’s tax filing due date (plus extensions). In addition, the Guideline plan document requires employer contributions to be contributed before their tax filing due date (plus extensions).
What if I need to make contributions after we already filed our taxes?
If a contribution is required to be made to a plan to fix a compliance test or because it is required by the Plan Document, it still must be made even if the normal deadlines have passed. As noted above, ideally the contributions are made no later than the end of the following plan year and before an employer’s tax filing due date (plus extensions).
If contributions are made after these deadlines, there are several possible impacts to a plan:
The late contribution may be subject to lost earnings for the period it was not invested in the plan. Guideline will not automatically calculate lost earnings if the contribution is made within the year following the plan year. Let Guideline know if you are past your tax filing due date (plus extensions) and earnings are due to participants.
The late contribution will lower the deduction limit (25% of total compensation for each plan year) for the following tax year. If the deduction limit is exceeded, an excise tax applies. Plan sponsors must consult with a qualified tax advisor to ensure requirements are met. Sponsors are also responsible for working with their business tax advisor to report employer contributions and handle any applicable excise tax filings.
If a contribution is made more than 30 days after the tax return due date (plus any requested extensions), the contribution will count against the following year’s annual additions limit. Let Guideline know if you have already filed your taxes more than 30 days before the contribution is made.