If you received a 401(k) plan refund check, here’s what to do

  • If you got a 401(k) refund check, the IRS likely didn't find your company plan up to snuff.
  • Check whether your employer plans to make any changes in the coming year to allow you to invest as much as you'd hoped.
  • If not, there are other financially sound ways to apply those erstwhile 401(k) contributions, such as paying off high-interest debt and starting a taxable investment account.

If you contributed to a 401(k) plan at work and received a refund for a portion of your contributions, then chances are your plan failed Internal Revenue Service compliance testing.

IRS guidelines require 401(k) plans to meet certain criteria known as "annual contribution percentage" and "annual deferral percentage" to determine the amount participants are able to contribute.

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The reason a person receives a 401(k) refund check is most likely that the employer's plan has failed one or both of these tests, which prevents the employee from contributing above a certain amount. And that occurs when eligible participants in the company's 401(k) plan are not contributing enough of their income, and employers are not contributing a significant enough amount on the employees' behalf, either.

The reason why these so-called non-discrimination rules were initially put into place makes sense: to prevent owners and high-ranking executives from keeping the vast majority of company profits instead of paying better wages or offering retirement benefits to all employees.

However, many highly compensated employees — those who are currently making $120,000 or more — or long-tenured workers are not necessarily decision makers, executives or owners. There are also some companies where it's just too difficult to make a 401(k) plan work, for a variety of reasons, including issues related to specific industries, economic cycles and the age of the company.

So the big question, of course, is, What should I do after I get a 401(k) refund check?

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First, talk to your company's benefits administrator to see if any changes will be made to the plan in the coming year. Such changes would include converting to a "safe harbor" plan, instituting a profit-sharing contribution, more education to inform employees of the benefits of saving for retirement or an automatic enrollment of all eligible employees.

Better yet, ask if a matching contribution, if not currently offered, will be made by your employer or whether, if there is a match already in place, it will be raised. If no changes will be made, it is unfortunately likely that you will receive a check back next year if you try to contribute the same amount.

The IRS does offer information on how to fix a 401(k) if it fails the ADP or ACP non-discrimination tests, but it's not the easiest for most benefits administrators juggling multiple responsibilities beyond the 401(k) plan to understand. Employers should speak to a financial advisor with experience managing 401(k) and group retirement plans to determine the best course of action.

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Also, make sure you speak to an accountant if you have already filed your taxes. The refund check was most likely listed as a deduction and you will need to re-file an amended return showing the excess contribution. You will be responsible for paying taxes on the amount you receive back, but not the typical 10 percent penalty associated with early distributions, because it was a failure of the 401(k) plan, not you.

What should you do if you can't max out your 401(k) contributions due to failed testing? If you have taken all of the aforementioned steps — including consulting your employer or benefits administrator — and don't believe the necessary changes will be made in order to allow your desired contribution amount, here are some other things you can do with that refund:

Pay off debt. Do you have any credit cards with outstanding balances? Student loans? Mortgage? Use the funds to improve your debt-to-income ratio; in many cases, paying down your debt helps your financial life just as much as a retirement contribution.

Consider an individual retirement account contribution. Given you received a 401(k) refund check, you're a highly compensated individual. That doesn't, however, necessarily mean that you can't contribute to an IRA. Make sure to check the IRS deduction and contribution limits for both traditional and Roth IRA contributions and speak to your financial advisor or accountant to see if it makes sense for you.

"Giving to qualified organizations and worthy causes may provide a tax deduction and personal satisfaction from helping those in need."

Open a non-retirement investment account. We're often so focused on IRAs and 401(k) plans that it's easy to overlook a taxable investment account. You won't receive tax-free growth, but having liquid capital that you can access before retirement is important, too. Investments held for a period longer than 12 months receive long-term capital gains tax treatment, which is currently lower than ordinary income.

Take a well-deserved vacation. The honest truth is that your 401(k) refund seems like free money. Retirement can appear far away, and you probably considered that money gone in a way. You're doing great with your career and you're saving as much as you can for retirement, so go get some sunshine already.

Contribute to charity. Giving to qualified organizations and worthy causes may provide a tax deduction and personal satisfaction from helping those in need. Speak to your accountant to see what kind of tax benefits you may receive. Here are the IRS tax guidelines on charitable gift deductions.

— By Evan Kirkpatrick, CEO and wealth manager at Wendell Charles Financial

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