ADP Test Incorrect/ HCE Refunded Too Much

The employer has 200 participants and 1 HCE (the CEO) in a 401(k) plan. They ran their 2017 ADP test; it failed; they processed the ADP refund and forfeited the related employer matching contributions of the 1 HCE in March 2018. Late in the 2018 year, they determined that the ADP test was run incorrectly--ineligible employees who were not participants were included in the ADP test as 0% deferring.   As a result, the plan would not have failed the ADP test by as large of an amount and the HCE received too large of an ADP refund.  The HCE was distributed in 2018 more of his salary deferrals than he should have been (and more of his employer matching contribution were forfeited than should have been if the ADP refund were less) for the 2017 plan year. As a side note, the board of directors of the employer gave the HCE additional comp during 2018 to make-up for the HCE not being able to fully defer into the 401(k) plan and receive the full resulting employer match.

First, I believe the ADP test must be rerun correctly so that a correct ADP test is maintained in the employer's files  (even though we know that it will not indicate additional refunds that must be made, but an overdistribution of refunds)? But then what is the employer required to do? I've never seen this happen.

I've seen this several times in the past few years. 

While the cause of the error is the test, the actual error is overpayment of a distribution, which is addressed in EPCRS. 

The participant should return the money (adjusted for earnings), and the 1099-R can be adjusted (if not issued yet) or amended to reflect the portion that was correctly refunded to the HCE. 

If the participant refuses to return the money - and they would have been eligible for an inservice withdrawal ( typically over age 59 1/2) then basically the HCE has taken an in-service withdrawal of the extra $. 

If the participant refuses to return the extra $ -well there are other threads on here about what to do when distributions are too much and how to try to recoup or next steps. 

Presumably the forfeited match is still available, if not, the sponsor should make a deposit to the plan to cover the match that needs to be restored to the HCE's account. 

I've seen all of this done as self-correction (which is a decent option if fixed all within the same year - minimizes tax impact). I've also seen this done as a VCP, which is good too. 

Since the plan would have an annual IQPA I would also suggest checking with the auditor if they are the kind that are sticklers about things being done exactly their own way. 

Good luck. 

Thank you for your help. (In my opinion), employer's should never be put in the position of having to determine the data needed to run the ADP/ACP tests. Apparently, this is what happens when that occurs.

If the HCE/participant refuses to return the money, in the above link, it indicates that the employer is not required to deposit the overpayment if the amount incorrectly distributed was part of the participant's vested balance...which it was in this case (100% vested in salary deferral distributed and received only his vested portion of the ER match). In this case, the HCE/participant is NOT over 59 1/2, but the above link interprets that part of the Rev Proc as not requiring a payment by the employer, because the overpayment came from the participant's vested balance. So if the participant doesn't repay, then ER is not required to either (even though the participant isn't 59 1/2 yet)? I would think this would apply to both the ER matching contribution as well as the salary deferrals?  But appears that Form 1099-R should be issued so that the overpayment portion is subject to 10% early withdrawal penalty?

Will there be any repercussions or other issues (possible fiduciary issues) if the HCE/participant, who is the CEO, refuses to return the money? I'm going to hope he wants to return the money, but if he is unable to (for whatever reason), I'm just trying to anticipate their questions.

If the HCE/participant returns the money, that specific forfeited ER match contribution has already been utilized for other ER match contributions during the year. However, I would think that 'other' ER matching forfeitures could be utilized to restore his balance, and if there are none, then the employer would need to contribute it to the plan?

If the HCE/participant returns the money, is he required to repay earnings from the time of the distribution to the time of the repayment? How are these earnings calculated?

"So if the participant doesn't repay, then ER is not required to either (even though the participant isn't 59 1/2 yet)? I would think this would apply to both the ER matching contribution as well as the salary deferrals?  But appears that Form 1099-R should be issued so that the overpayment portion is subject to 10% early withdrawal penalty?"

- Yes, that's my understanding. 

"Will there be any repercussions or other issues (possible fiduciary issues) if the HCE/participant, who is the CEO, refuses to return the money? I'm going to hope he wants to return the money, but if he is unable to (for whatever reason), I'm just trying to anticipate their questions."

- Is he a fiduciary? If so, then yes. He may argue that his rights as an individual outweigh his responsibility as a fiduciary.But his responsibility as a fiduciary are to the plan and ALL of the participants. If a fiduciary knows of an error they are supposed to try to fix it. If he insists on not returning the money (and he is a fiduciary) then I would suggest he talk to someone about self-dealing, hopefully decent ERISA counsel. 

"If the HCE/participant returns the money, that specific forfeited ER match contribution has already been utilized for other ER match contributions during the year. However, I would think that 'other' ER matching forfeitures could be utilized to restore his balance, and if there are none, then the employer would need to contribute it to the plan?"

- Yes that sounds correct based on EPCRS

"If the HCE/participant returns the money, is he required to repay earnings from the time of the distribution to the time of the repayment? How are these earnings calculated?"

- The revenue procedure gives several reasonable ways to calculate earnings. I believe they are in Appendix A or B. Typically I would start by looking at actual earnings of two things 1.What the money earned while it wasn't in the plan. 2. What the money would have earned while in the plan. 

The actual earnings rate has some flexibility as long as it is reasonable, EPCRS allows use of the highest returning fund in the plan, the plan RoR as a whole, etc. I've seen each participant's actual rate of return calculated, etc. The actual mechanics of a RoR return calculation will vary based on how you weight contributions / distributions, calculate time involved etc. 

Perhaps most importantly - how are they going to prevent this from happening again? Will you be performing the ADP for 2018 instead of them? 

I should clarify - if the match was forfeited and kept in the plan - no 1099-R is issued for that money. 

The money that was correctly distributed (match and deferrals - did ACP fail too?) gets a 1099-R showing no 10% penalty. 

The money that was incorrectly distributed (Match and deferrals? ) gets a 1099-R, sounds like with code 1.

If only the ADP test failed I would expect to see deferrals refunded and attributable match forfeited. But it sounds like match was distributed - maybe that's part of the incorrect distribution? - so yes, if that's the case it gets taxed.  

I know I'm years late to this discussion, but I'm re-reading the first part here of the original post and have a question.... shouldn't the employer always provide a census that includes all employees who received payment that year, whether they were eligible or not?  The testing, which is handled by the recordkeeper or TPA, should then field out those who were ineligible?  Is that correct?