All 401(k) plans are required to pass several annual nondiscrimination testing (NDT). While it’s not uncommon to fail one or more of these tests—especially for small businesses—luckily, taking action can help your business avoid long-term consequences and penalties.
One of the more common scenarios is failing the Actual Deferral Percentage (ADP) or Actual Contribution Percentage (ACP) test. A QNEC is an employer contribution made to a plan to help it pass the ADP test or ACP test, or as part of a correction process.
QNECs are subject to the same restrictions as deferrals, meaning they’re immediately 100% vested and cannot be distributed before the employee’s death, disability, severance of employment, attainment of age 59 ½, or in the case of a hardship (as permitted by the plan).
For more information on calculating QNECs—including how they’re used in corrections and missed contributions—refer to the article below.
When QNECs are used in corrections
A plan operational error is triggered by one of the following events:
An eligible employee is excluded from plan participation
An eligible employee fails to be enrolled under a plan’s Automatic Contribution Arrangement
When there’s a failure to implement a participant’s deferral election
Under the IRS Employee Plan Compliance Resolution System (EPCRS), employers can correct these errors by contributing a QNEC to the participant. The QNEC represents an opportunity for the participant to defer on a passed opportunity. The QNEC amount is based on the facts and circumstances that include the type of plan involved (ACA or not), and the length of the error. The QNEC will be between 0% and 50% of the failed election, plus 100% of the missed match on the amount that would have been deferred if the error hadn’t occurred.
The QNEC should be allocated to the QNEC “source” in the plan’s recordkeeping system. The match may be placed in the discretionary match source or the QNEC source, but should be done so consistently across plan years. QNECs for deferral corrections are always adjusted for earnings. EPCRS includes multiple options for determining earnings. (The DOL VFCP calculator is not one of them and is not applicable for this purpose.)
Determining QNEC percentages for missed contributions
|QNEC amount due to missed deferral opportunity||Criteria|
•Participant is provided notice within 45 days of start of correct deferrals
•Employee has not terminated
|40%||Plans with after-tax elections not implemented/changed would require a 40% QNEC plus a corrective matching contribution.|
|50%||If a plan cannot meet any of the criteria above and correct deferrals begin by the last day of the third plan year after the plan year in which the failure first began.|
In all cases of QNECs (including 0% contributions), the associated match should be contributed as a corrective matching contribution. This is calculated using 100% of the missed deferral opportunity no later than the second year following the year in which the error occurred. This match can be subject to vesting and placed in the discretionary matching source but should be noted appropriately so it’s not forfeited at year-end (as it may cause the plan’s match verification calculations to exceed the match formula for the year).
QNECs for missed deferrals must also be contributed no later than the second year following the year in which the error occurred and should also include investment gains for the time period from the original deferral date until the deposit is made.
Have additional questions and are already a Human Interest customer? File a ticket here if you need assistance with your earnings calculation methods.
Determining the QNEC amount for missed contributions
What deferral election should be used for the QNEC calculation?
If the participant has elected a specific percentage to defer, use that.
If it’s a change to an election that was missed (including missed escalations), the QNEC is based upon the difference between the election used vs. the election requested
If there’s no election on file (for those improperly excluded) use the following:
Prior year average ADP of non-highly compensated employees (NHCEs) for non-safe harbor plans; or
The default rate for an ACA plan; or
3% or the highest deferral rate receiving a 100% match for safe harbor plans
For after-tax elections, if the participant was excluded, you may use the prior year ACP NHCE average exclusive to after-tax elections.
Calculating earnings on a QNEC correction
Generally, you should always calculate the actual earnings on the correction. However, this is often inconvenient due to time constraints or the number of participants involved. Therefore, the IRS states that an estimate is allowed when you cannot calculate the exact amount of earnings (due to missing plan information, etc.). Whenever estimates are made, they should be applied consistently with corrective contributions or allocations for that plan year.
Allowable methods include:
If most of the employees for whom the corrective contribution is made are NHCEs, the plan fund’s highest Rate of Return for the period*
Affected Participant(s) fund’s highest Rate of Return for the period*
For those with no elections, the QDIA return for the period*
Plan’s rate of return for the period*
Participant’s rate of return for the period*
For improper exclusions, you can also use a midpoint function for the time the deferrals were missed as a loss date to calculate a Rate of Return
*Period would be the loss date to the date of deposit of the earnings
Note: You may not use the VFCP calculator to determine lost earnings for QNECs.
QNECs as an ADP or ACP correction (may only be used if a plan uses current year testing method)
When a plan fails ADP or ACP testing and the plan is using the current year method, one option to correct the test is for the plan sponsor to provide a QNEC that would allow the plan to pass for the year. For example, if the NHCE average needs to be increased by 0.5% to ensure the highly-compensated employee (HCE) average passes, a plan sponsor would contribute a 0.5% QNEC contribution to all eligible NHCEs for the year which could then be included in the ADP or ACP test to allow for a passing HCE average.
If a plan fails both the ADP and ACP tests, the QNEC cannot be double-counted. Therefore, when a QNEC is contributed to correct ACP tests, it’s often called a Qualified Matching Contribution (QMAC) to differentiate the corrections. The corrective QNEC or QMAC must be made within 12 months of the end of the plan year for which it applies. Because of this rule, plans that use prior year testing methods for ADP or ACP testing cannot contribute a QNEC to pass ADP or ACP testing, as the test uses information greater than 12 months prior.
Need more information? Learn how QNECs and QMACs can help correct a failed 401(k) nondiscrimination test. Or, you can request more information about Human Interest today.
Article ByWendy Baker, J.D.
Wendy Baker is Senior Legal Counsel at Human Interest, bringing over 25 years of experience exclusively in the ERISA space, spanning defined contribution plan recordkeeping and administration. She has a J.D. from Case Western Reserve University, is a member of the North Carolina and Ohio Bars, the American Bar Association, and industry groups.