Three Strategies to Eliminate Corrective Distributions
One of the reasons that a business offers a retirement plan is to provide a convenient means for employees to save for their future. Both new and current employees rate 401(k) plans and other similar programs as a very important benefit.
Plans are required to test for a balanced fairness as to who is deriving benefits. In some situations, certain highly compensated employees are not able to save as much as they would like. This is due to an imbalance between average deferrals by non-highly (NHCEs) and highly compensated employees (HCEs). The result is a corrective distribution (refund) to the HCEs shortly after the end of the plan year. The IRS defines a HCE as an individual who…
Owned more than a 5% interest in the business at any time during the year or the preceding year, regardless of how much compensation that person earned or received, or
For the preceding year, received compensation from the business of more than $120,000 (if the preceding year is 2015 - 2018 and $125,000 if the preceding year is 2019), and, if the employer so chooses, was in the top 20% of employees when ranked by compensation.
A plan sponsor can employ three effective strategies to reduce or eliminate future corrective distributions to their HCEs.
Safe Harbor Election: A plan sponsor can eliminate elective and matching contribution testing if certain criteria are met. Safe harbor plans allow all employees the opportunity to make full contributions by utilizing a level of matching deemed non-discriminatory. If all eligible employees participate, a plan sponsor can expect to contribute up to 4% of compensation on behalf of those participants.
Automatic Enrollment combined with Automatic Escalation: Eligible plan participants are automatically enrolled in the plan. Once a year, the deferral percentage increases by a pre-determined amount up to an overall limit. For example, the initial deferral might be 4%, increasing by 2% each year until a limit of 12% is reached. Participants may opt out of the enrollment or any of the increases. Interestingly, national figures show that only around 6% of those automatically enrolled decide to opt out. Corrective distributions tend to lessen over time as the average deferral percentage increases for the non-highly compensated.
Prior Year Testing Method: This method allows the plan to compare the prior year deferral and compensation amounts for NHCEs to the current year HCE deferral and compensation amounts. The prior year testing method provides employers with the information necessary to limit the HCE contributions in advance. In theory, this means the plan is less likely to fail the discrimination testing and could avoid a corrective distribution.
Each of these strategies has their place. Keep in mind that improving an employee’s retirement readiness helps the business and employees. Thoughtful consideration can lead to more appreciative employees.
