3810 / What is a QNEC and how can a 401(k) plan that has failed its nondiscrimination testing use QNECs to correct the failure?

A plan may provide for an employer to make fully vested contributions for certain nonhighly compensated employees. These contributions then are included as deferrals in the ADP testing and, if sufficiently significant, can cause the plan to satisfy the ADP testing.

Recharacterization. Excess contributions of highly compensated employees may be recharacterized as after-tax employee contributions only to the extent that the recharacterized amount, together with the amount of any actual after-tax contributions, satisfies the ACP testing.¹ This amount is treated the same as a match in that testing.² Note that these recharacterization rules are different than the recharacterization of Roth IRA conversions eliminated under the 2017 tax reform legislation.

Recharacterized excess contributions must be included in an employee’s gross income on the earliest date any elective contributions made on behalf of the employee during the plan year would have been received. The payor or plan administrator must report such amounts as employee contributions to the IRS and the employee.³ These recharacterized contributions continue to be treated as employer contributions that are elective contributions for all other purposes under the IRC (for example, they remain subject to the nonforfeitability and withdrawal requirements applicable to elective contributions).⁴

On July 20, 2018, the IRS published final regulations that modify the definitions of QNEC to allow employers to use forfeitures in order to pass nondiscrimination testing that applies to qualified plans. Under the proposal, QNECs need to be nonforfeitable and subject to certain distribution restrictions when they are allocated to participants’ accounts, rather than when they are first contributed to the plan. This amendment generally broadens the definition of contributions that qualify as QNECs and permits plan sponsors that allow the use of forfeiture accounts to offset future employer contributions under the plan. Therefore, the final regulations would require that QNECs be fully vested only when they are allocated to the participant’s account. The changes apply to taxable years ending on or after July 20, 2018.⁵