3808 / What happens if a 401(k) plan fails its nondiscrimination testing?

A plan’s continued tax qualification is conditioned on its meeting the operational requirements of IRC Section 401(c). For a 401(k) plan, that includes passage of annual ADP and ACP testing. When that testing fails, a plan is required either to make certain additional contributions for the nonhighly compensated employees ( Q 3810) or certain distributions to the highly compensated employees ( Q 3809).¹ Thus, a failure to make these corrections for a failed test is an operational failure that could lead to a loss of the plan’s tax qualification.

When a 401(k) plan fails the ADP testing and elects to distribute certain deferrals to highly compensated employees, those deferrals are referred to as excess contributions.

When a plan’s matching contributions fail the ACP testing and the plan elects to distribute certain matching contributions to highly compensated employees, those matching contributions are referred to as excess aggregate contributions ( Q 3811). The complexity of the ADP and ACP tests, as well as that of the rules that follow, have led many employers to implement design-based plans that are deemed to satisfy these tests ( Q 3773, Q 3778).²