States With the Most Corrective Distributions

The study by Judy Diamond Associates, a 401(k) plan intelligence provider, reveals that a total of 57,277 401(k) plans failed their 2012 nondiscrimination tests. These plans were then required to return $794 million in 401(k) contributions to highly compensated employees (i.e., corrective distributions), resulting in increased income taxes and lower retirement savings for those participants.

The top five states for issuing corrective distributions for the 2012 plan year were:

• Kansas (with 13.03% of plans issuing corrective distributions);
• Texas (12.79%);
• New Jersey (12.49%);
• Georgia (12.12%); and
• Alabama (11.95%).

The states that had the lowest percentage of plan issuing corrective distributions include:

• Montana (6.18%);
• Hawaii (7.24%);
• Wyoming (7.61%);
• West Virginia (7.93%); and
• Idaho (8.01%).

The Internal Revenue Service requires 401(k) plans to undergo nondiscrimination testing to ensure that both highly compensated participants and rank-and-file participants contribute to the plan at similar rates. When owners and managers of a company contribute at far higher rates than their employees during the year, the plan must return some of the highly compensated participants’ employee contributions, also known as corrective distributions, which then become subject to normal income taxes (see “The Tests You Don’t Want to Fail”).

Employers can use a number of options to improve their chances of passing nondiscrimination testing. One such approach is the use of a QNEC, or qualified nonelective contribution, on behalf of non-highly compensated employees in the plan. A QNEC is an employer contribution that can be used by 401(k) plans to ensure that testing requirements are satisfied without having to refund contributions to highly compensated employees. Other options include using a different form of compensation for nondiscrimination testing, the use of permissive disaggregation, or switching from prior year to current year testing (see “Improving Nondiscrimination Test Results”).

“The issuance of corrective distributions should serve as a red flag to plan sponsors. It means that the plan has highly compensated employees who were unable to save as much for their retirements with pre-tax income as they would like. It may also mean that the plan is not designed to encourage workers to contribute sufficiently. Plan sponsors can utilize this information by introducing retirement education programs and suggesting better 401(k) savings methods to participants,” says Eric Ryles, managing director of Judy Diamond Associates, based in Washington D.C.

Plans that issue corrective distributions may have other issues with their design, says Ryles, which may include inadequate fidelity bonds, incorrect calculation of vesting schedules or failure to amend plans in a timely period to conform with current laws and regulatory changes.

The study also shows that:

• Nationwide, 12% of 401(k) plans issued corrective distributions in 2012;
• Corrective distribution issuance was down about 2% from the previous year; and
• Small states, proportionally, had fewer plans that issued corrective distributions than big states, which most likely reflects the locations of highly compensated workers.

Judy Diamond Associates based this research on the most recently available complete set of 401(k) plan disclosure documents released by the Department of Labor, in combination with the firm’s Retirement Plan Prospector database and plan analysis tool.

More information about this research can be requested at www.judydiamond.com/about/contact.