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