The IRS requires 401(k) plans to pass compliance testing to ensure the 401(k) benefits all employees in a plan fairly. This is separate from the annual limits and rules for each individual's contributions.
If you received a refund, that means your plan failed these tests, your employer decided to refund excess contributions back to Highly Compensated Employees (HCEs), and you were considered a HCE.
What are the compliance tests?
The Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests are both used to ensure that a plan is not operated in a way that favors owners and highly paid individuals, called Highly Compensated Employees (HCEs), or in a way that works to the detriment of rank and file employees called Non-Highly Compensated Employees (NHCEs).
The ADP test is performed to determine if the plan is allowing HCEs to contribute via salary deduction in too great an amount when compared to NHCEs, while the ACP test looks at whether employer matching contributions favor HCEs when compared to NHCEs. If your company has a Safe Harbor plan, it's exempt from these tests.
Who is considered HCE vs. NHCE?
A Highly Compensated Employee (HCE) is:
An employee making over $150,000 in 2023 (this limit may be changed by the IRS each year); AND
An employee who is in the top 20% when ranked by compensation; OR
Someone who owns more than 5% of the business in the current or prior year; OR
A family member of someone who owns more than 5% of the business.
Everyone else is considered NHCE.
How does this affect my income taxes?
If you received a refund, your W-2 income remains unchanged, but you'll receive a 1099-R the following February to report the taxable amount. This will be used in preparing the tax return for the year in which you received the refund.
Refunds are issued after the end of the year and are taxable as ordinary income in the year distributed (not the year contributed). Any gains for ADP/ACP refunds are also calculated and refunded with the check. For example, if excess contributions must be returned to HCEs for the 2022 plan year, these will typically be refunded in 2023 and should be reported on your 2023 tax return when you prepare taxes in 2024.
Unlike other cash distributions, these 401(k) refunds are not subject to early distribution penalties and the amounts cannot be rolled over to an IRA. By default, 20% federal tax is withheld. If the refund of your elective deferrals has a match associated with it, that amount may be forfeited.