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Thousands of 401(k)s fail nondiscrimination test

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Nearly 60,000 401(k) plans failed their most recent nondiscrimination tests, according to research by Judy Diamond Associates.

The IRS requires highly compensated plan participants and rank-and-file employees to contribute similar rates to their retirement plans. If the IRS finds an imbalance that favors wealthier employees, plans are required to return contributions to employees, after which the money is taxed as regular income. The process is known as a corrective distribution.

Judy Diamond Associates, a retirement plan data publisher and a division of LifeHealthPro’s parent company, Summit Professional Networks, found that 57,277 401(k) plans failed their most recent nondiscrimination tests. 

In 2012, the year for which the most recent data is available, $794 million in contributions were returned to highly compensated employees. Nationwide, 12 percent of 401(k) plans issued corrective distributions, Judy Diamond Associates said, about 2 percent down from the previous year.

Small states, proportionally, had fewer plans that issued corrective distributions than big states, most likely a reflection of where highly compensated workers can be found.

Corrective distributions, of course, mean more money to Uncle Sam, and less to retirement savings.

JDA Table on Corrective Distributions

While the facts are nettlesome for affected enrollees, and administratively burdensome to sponsors, Eric Ryles, managing director of JDA, says the corrective distribution trend could signal real opportunity for RIAs looking to increase their 401(k) business.

The issuance of corrective distributions means a “plan has highly compensated employees who were unable to save as much for their retirements with pre-tax income as they would like,” explains Ryles. “It may also mean that the plan is not designed to encourage workers to contribute sufficiently.”

Ryles says that plan advisors can utilize data on corrective distributions in their prospecting efforts, as their incidence suggest an education void in a plan and possibly the need to restructure design and contribution rates. 

IRS research also suggests corrective distributions tend to indicate systemic issues with a plan’s design.