My company failed the HCE/ACP test on 401K and created a distribution. How do I file the distribution to avoid penalty pay?

[dmertz · Accepted solution]

The code in box 7 of the Form 1099-R that reports this distribution will indicate that the distribution is not subject to penalty.  There will be no code 1 in box 7.

[soymisto]

Thank you for the quick response!

[Boyan]

@dmertz  Phew thank you for clearing that up about the 1099-R box; however in my case the plan had labelled "Distribution Code 1: 8" which is the "no known exceptions code" so I'm screwed, they should've used Code 2 but that's something for me to deal with (8 is the qualified reason code that goes along with code 1 - excess contributions)

However what about the fundamental issue? Is there anyway one can decrease their income below the HCE limit so that one's contributions then can maximize the federal limit? It sounds like HCE/ACP test in the ERISA act was created to penalize those who plan well, make high wages and ...

The HCE test is pretty simple, for example for 2023 it's $150k -- what could one do to reduce their earnings to $149k for example? Any vehicle that's available to us? Even if it's wasting money like some kind of political contribution, etc? I'm barely scratching the HCE limit and as a result get heavily penalized just because my co-workers don't plan, don't save and as a result drive the average contribution ratio for the entire plan participants population low...which then becomes the basis for the contribution limits imposed on HCEs

Thanks

[dmertz · Accepted solution]

A corrective distribution from a qualified retirement plan like a 401(k) should never have a code 1 along with code 8 because such distributions are never subject to an early distribution penalty.  Code 1 should only be used with code 8 for some returns of contributions from IRAs, indicated by the IRA/SEP/SIMPLE box being marked, and only those made before December 29, 2022 when such penalties were eliminated by the SECURE 2.0 Act.  If the Form 1099-R has both codes 1 and 8 but the IRA/SEP/SIMPLE box is not marked, I would probably claim an exception to the early-distribution penalty with code 12 (incorrectly indicated as an early distribution) on line 2 of Form 5329.

ADP and ACP tests were put into the tax code because Congress thought that HCEs could benefit from the plan inequitably compared to non-HCEs in the same plan if there were not some limitations.  Moving below the HCE income threshold would require being paid less.  Another option would be to promote the plan more vigorously to non-HCEs to raise their percentage.

[Boyan]

@dmertz  Yep the custodian screw up. For the benefit of our community here's an example of how they screwed up:

[dmertz]

No.  It's fine.  It says that Code #1 (of 2 possible codes) is 8.  There is no second code, no code 1.  If there was also a code 1 it would say:

Distribution Code 1:  1

Distribution Code 2:  8

(or vice versa)

Payers who use substitute forms that do not conform to the format of the actual IRS Form 1099-R often create such confusion.