What are 401(k) Corrective Distributions?

What are 401(k) Corrective Distributions?

If you offer a 401(k) plan at your business, you’re already helping your team build a better financial future. But with that comes a bit of responsibility, especially when it comes to compliance testing and something called corrective distributions.

Don’t worry, it’s not as scary as it sounds. Let’s break it down together.

What is a 401(k) Corrective Distribution?

A corrective distribution happens when your company has to return some of the 401(k) contributions made by highly compensated employees (HCEs)—usually your top earners or company owners.

Why? Because the IRS wants to make sure your 401(k) plan is fair for everyone, not just the high earners. If HCEs contribute way more than everyone else, your plan could fail a test called nondiscrimination testing.

Who Counts as a Highly Compensated Employee?

In 2025, an HCE is anyone who:

• Owns 5% or more of the company, or
• Earns more than $160,000 in the year

Everyone else is considered a non-highly compensated employee (NHCE).

Why Do Corrective Distributions Happen?

A Quick Example

Let’s say your NHCEs contribute an average of 4% of their salary. Your HCEs contribute 7%. That’s too big of a gap.

To pass the test, your HCEs can only contribute up to 125% of what NHCEs do—in this case, 5%. So, you’ll need to return enough of the HCEs’ contributions (plus estimated earnings) to bring their average down to that level.

Heads up: These refunds become taxable income for the HCEs.

When Do Corrective Distributions Happen?

The IRS gives you 2.5 months after the plan year ends to fix any issues.¹ So if your plan runs on a calendar year, you’ll likely deal with this between January and mid-March.

How Can You Avoid Corrective Distributions?

Great question! Here are a few smart moves to help your plan stay in the clear:

1. Run Mid-Year Compliance Checks: Many 401(k) providers offer mid-year testing—take advantage of it! It gives you time to spot and fix imbalances before year-end.
2. Keep Your Data Clean: Make sure your payroll and employee census data is accurate and up to date. Bad data = bad test results.
3. Consider a Safe Harbor 401(k): A Safe Harbor plan automatically passes nondiscrimination testing. It requires certain employer contributions, but it can save you a lot of hassle (and refunds) down the road.

What If You Fail the ACP Test?

Good news: Not all test failures require corrective distributions. If your plan fails the ACP test, there are other ways to fix it, like making additional employer contributions to NHCEs.

The Bottom Line

Corrective distributions aren’t the end of the world, but they are a sign your plan might need a little tuning. Many 401(k) providers offer free mid-year compliance checks, giving you a chance to catch any imbalance in contributions before it becomes a problem. By staying proactive with testing, keeping your data clean, and considering plan design options like Safe Harbor, you can keep your 401(k) fair, compliant, and working for everyone.

Let’s Talk

We’re here to help you and your employees navigate the complexities of 401(k) plans and saving for retirement. Contact us to talk about what your business needs.

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