Corrective distribution and QNEC

What these fixes are

When a plan fails the ADP or ACP test, there are two ways to correct it.

A corrective distribution returns excess contributions, with earnings, to highly compensated employees (HCEs), starting with those who contributed the most dollars. The refund is taxable to the employee in the year it is paid, and any match tied to refunded deferrals is forfeited.

A qualified nonelective contribution (QNEC) is an employer contribution made for non-highly compensated employees that raises their average enough to pass. It must be 100% vested and is subject to the same withdrawal restrictions as employee deferrals.

Why it matters to employers

Refunds cost the company nothing directly, but they frustrate the executives who receive an unexpected tax bill. QNECs avoid refunds but cost cash. Timing matters:

• Refunds within two and a half months after the plan year (March 15 for calendar-year plans) avoid a 10% employer excise tax. An EACA covering all eligible employees has six months.

• Either fix must be completed within 12 months after the plan year ends. After that, the plan has to use the IRS correction program, which is more expensive.

Example

A plan fails the 2026 ADP test by $6,000. On March 1, 2027 it refunds $6,000 plus earnings to three HCEs. Each reports the refund as 2027 income. No excise tax is due because the refund was made by March 15.

Common mistakes

• Missing the two-and-a-half-month window and owing the excise tax on Form 5330.

• Refunding the wrong people. The dollar amounts are assigned by a set method.

• Leaving the related match in the HCE’s account.

• Treating a refund of excess deferrals over the $24,500 limit the same way. That is a different correction with an April 15 deadline.