3809 / What are the rules that apply when a 401(k) plan fails its nondiscrimination testing and elects to distribute excess contributions in order to correct the failure?

An otherwise qualified 401(k) plan with a failed ADP test will not be disqualified if, before the end of the following plan year, any excess contributions are distributed along with any allocable income. Additional contributions (“QNECs”) may be made to the plan by the employer to the accounts of the nonhighly compensated employees sufficient to pass ADP testing.¹ Another seldom-used option permits recharacterization of these deferrals by treating them as if they had been distributed to the employee and then contributed by the employee to the plan on an after-tax basis. These after-tax employee contributions then are included in the ACP testing. Excess contributions may not remain unallocated in the plan or held in a suspense account for allocation in future years.²

Excess contributions are to be distributed (or otherwise corrected) within 2½ months after the end of the plan year to avoid the employer being subject to a 10 percent excise tax on the amount distributed.³ A plan that contains an automatic enrollment (even if not an “eligible automatic contribution arrangement”) is subject to an extended time period for distributing refunds of excess contributions of six months rather than 2½ months.⁴

An excess contribution may consist of elective salary deferrals, Roth employee contributions, QNECs and QMACs, and certain employer contributions, all of which are included in ADP testing.⁵ A plan will specify whether an ordering of the distributions is required ( Q 3737). Salary deferrals and Roth contributions that exceed $23,500 in 2025 ($23,000 in 2024, $22,500 in 2023, $20,500 in 2022, $19,500 in 2020-2021) are referred to as “excess deferrals” ( Q 3760) and should not be confused with excess contributions. Special rules apply for coordinating distributions of excess contributions and excess deferrals.⁶

Excess contributions and income thereon distributed to an employee are treated as earned and received by the employee in the year in which the distributions are made.⁷

Where the plan specifies, or where the employer elects to make corrective distributions of excess contributions and the distribution is not made within 2½ months after the close of the plan year (or six months if the plan has an automatic enrollment feature), two requirements are triggered. The employer pays a penalty of 10 percent of the excess distribution,⁸ and a statutory 12 month period applies. If the distribution occurs more than 12 months after the close of the plan year, the plan has an operational failure that must be corrected under EPCRS to avoid the plan’s disqualification.⁹

Corrective distributions of excess contributions may be made without regard to the spousal consent rules ( Q 3882).¹⁰ Corrective distributions may not be considered for purposes of satisfying the minimum distribution requirements ( Q 3891 to Q 3909).¹¹