My 401k failed the nondiscrimination test -- how to avoid taxable distribution?

Question

As in this question, and this question, my ex-company's 401(k) failed the nondiscrimination test.

I've recently received a letter from the company's HR to the effect that I will receive a corrective distribution (of unspecified amount) that will be taxable as 2019 income. I will receive a tax reporting form (presumably 1099R) in Jan 2020. The letter does not indicate that any tax will be withheld from the distribution.

My question is slightly different. I have already left the company, and I want to avoid a taxable distribution, which would be a setback to my retirement savings. I have two ideas:

1. Is it legal for me to try to quickly execute a direct rollover to my IRA in order to empty my 401(k) before this distribution takes place?

2. If I do get a corrective distribution, am I allowed an indirect rollover of this amount into a single IRA, provided I do so within 60 days? (Or, is this nondiscrimination distribution subject to additional restrictions?)

Are these ideas viable? What other options do I have?

Answer 1

Executing a rollover won't let you keep an excess contribution in tax-advantaged status. Corrective distributions are not really distributions at all; they undo contributions. In particular, they aren't eligible to be rolled over.

Your proposal #1 may be legal insofar as you won't go to jail, but that won't save you from the penalties on excess contributions.

Moving the money to an IRA is just going to put you through paperwork hell. You'll have to track gains on the excess contribution across all the accounts they've transited through, and pay the penalty each year until you remove the excess.

Let the company fix it.

Answer 2

Why this happens?

Some companies routinely fail these nondiscrimination tests, often because their employer match is very poor.

If internet searches are any indication, this appears to be especially common for ex-employers; probably for the following reasons:

• average tenure time in tech is just 3 years;
• only HCE are subject to refunds, and you've had to have worked for a company for a few years prior to having income in the plan year prior to the plan year being tested (e.g., two years ago) of 130k or more in order to even be an HCE in the first place;

Here's a few ways to minimise the impact:

• NEVER front-load the full 19.5k of Pre-Tax/Roth 401k BEYOND guaranteed fully-vested employer match in Jan/Feb alone:

  • what happens here is you're screwing your own ability to get an actual proper match later in the year should you switch the job, because the 19.5k limit is shared across all employers, and a former employer may or may not issue you a refund just so that you can get a better match at a new job;
  • once you're an HCE yourself, you're screwing every other HCE by significantly increasing Actual Deferral Percentage (ADP) average should you leave mid-year, since you may be contributing as much as 90% (or more) of your income if you leave before March 1, where the average numbers may have to be in the 5% range in order to pass the testing; see 401k refund if an HCE front-loads 19.5k, leaves on March 1, and the ADP test fails? for an explanation on how just 1% of employees doing this can seriously mess up the whole plan and all the participants by increasing the HCE average by a whole percentage point;
  • even if you don't leave mid-year, depending on how employer match works, you may end up having to wait extra time to get a True Up on Company Match, and/or even miss it entirely;

If you've already front-loaded this year beyond vested company match, and have since switched jobs:

• try to contact your old company proactively right away and before EOY to see if they can issue you an overcontribution refund if you intend to contribute to 401k at another employer; it's unclear if it's even possible, usually it's only done at a second employer in the year if your contributions at the second employer exceeds the total 19.5k limit for the whole year; it's possible that a prior employer might be able to do something like that as well; this way you could still contribute the full 19.5k at your new employer, and you're guaranteed to not get a refund there because you're an NHCE since your prior year's compensation from the new employer is $0.00, which is below the 130k threshold for being classified as HCE in the first plan year (you'd become an HCE in either the second or the third plan year, depending on the partial-year compensation in your first year at the new job).