What Every 401(k) Admin Should Know About Corrective Distributions

Who Are Highly Compensated Employees and Why Do They Matter to Your 401(k)?

The IRS has rules for 401(k) plans to ensure that there’s balance in how benefits are distributed across the company. Sometimes “highly compensated employees” (HCEs) contribute significantly more to their 401(k) accounts than “non-highly compensated employees” (NHCEs), which can throw the plan out of balance. HCEs are defined as those who own 5% or more of the company or will earn more than $160,000and are in the top 20% of salary in 2025

If compliance testing finds HCEs benefit disproportionately more than NHCEs, the employer will have to either contribute more money to the NHCE accounts or force the HCEs to take back some of their contributions and pay associated taxes. These payments are called corrective distributions.

What Is Compliance Testing?

In the first quarter of the financial year, 401(k) plans must undergo compliance testing to determine whether HCEs receive or own a disproportionate amount of the retirement plan’s assets. If they do, a plan may need to make corrective distributions. This means that the plan must return some of the money that HCEs contributed to the 401(k).

There are two compliance (also called nondiscrimination) tests that every 401(k) plan must pass each year to make sure that highly compensated employees aren’t benefiting significantly more than everyone else.

Our compliance calendar and checklist can help you plan ahead for compliance testing and keep on top of other important dates.  Download it here.

Why Do Some Plans Fail Compliance Testing?

There are multiple ways that your plan can fail ADP testing, and all involve calculations that weigh how much more HCEs contribute vs. rank-and-file employees. If a plan fails ADP testing, the employer must make “corrective distributions” to HCEs to bring their average savings rate below the disparity threshold, which is generally 2%.

For example, let’s say compliance testing on a 401(k) plan reveals that, as a group, NHCEs contributed an average of 4% of their salary as pretax savings, while HCEs saved 7%. To get HCE contributions to 6% or less, the employer must make a corrective distribution, which involves cutting checks to return the excess contributions. When this money is returned, it again becomes taxable income.
For more tips on how to survive compliance season, check out our blog post “The Keys to 401(k) Compliance Testing Success”.

When Do Corrective Distributions Happen?

The IRS dictates that corrective actions must be made within 2.5 months of the year’s end. ²  If your business operates on a January to December fiscal year, you will likely encounter compliance testing and actions like corrective distributions between January and March.

How Can You Prevent the Need for Corrective Distributions?

While testing is required once a year, you don’t have to wait for the new fiscal year to evaluate your plan. Many 401(k) providers offer mid-year compliance testing at no additional cost, so you can spot an imbalance long before the time comes to take corrective action.

Accurate data is another hallmark of a healthy 401(k) plan. Make sure your 401(k) advisor has access to the correct payroll data and that you don’t let employee census information become outdated. Finally, there are some measures you can take to update your plan, like adopting a 401(k) Safe Harbor  provision so your plan automatically passes nondiscrimination testing.

As mentioned above, ADP testing is only one part of compliance testing. When plans fail ACP tests, there are methods other than corrective distributions to make sure every employee is receiving a fair benefit from your company’s retirement plan.

Have More Questions About Corrective Distributions?

We can help you rebalance your 401(k). Contact us to talk through the challenges you’re facing and what it will take to administer your plan effectively.

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