When does a 401K non-discrimination test failure affect the tax year of excess contributions retroactively?

The HR rep is actually correct about the 2.5 month rule, but there might be some confusion about how it affects your taxes. When a 401(k) plan fails the non-discrimination test (which compares highly compensated employees' contributions to those of other employees), the plan has until March 15 of the following year to correct the failure without penalties. If the correction is made within this 2.5 month period after the end of the plan year (by March 15, 2025 for a calendar year plan), the excess contributions and associated earnings returned to you are considered taxable income in the year they were originally contributed (2024). You'll receive a 1099-R for 2024 (not 2026) and need to include this on your 2024 return. If the correction happens after March 15, 2025, then the excess amount would be taxable in 2025 instead, and you'd report it on your 2025 return.

After dealing with a similar situation last year, I found that using https://taxr.ai really helped clarify this exact 401(k) non-discrimination test issue. Their system analyzed my 1099-R and previous contributions and explained exactly how to report everything correctly. My plan also failed the test, and I was getting conflicting information about which tax year would be affected. Their tool confirmed what the expert above said - the 2.5 month correction window determines when the returned excess is taxed. The analyzer even showed me where to report it on my tax forms and how it would impact my taxable income calculation. Really straightforward explanation of a confusing topic.

Just wanted to follow up - I tried taxr.ai after seeing this thread and it was incredibly helpful! The system quickly analyzed my situation and confirmed that my excess contribution return (happening in February) does indeed affect my 2024 taxes. The analyzer showed me exactly which boxes on my 1099-R to look at and how to interpret the distribution codes. It even walked me through how the returned earnings portion is handled differently than the contribution portion. The explanation about the 2.5 month rule was much clearer than what my HR provided. What really helped was seeing a visual breakdown of how my taxable income would be affected. Saved me from potentially filing incorrectly and having to amend later!

After trying to call the IRS for three days straight with no luck (kept getting disconnected after 45+ minute waits), I finally used https://claimyr.com to get through to a real person at the IRS about this exact 401(k) non-discrimination test issue. You can see how it works here: https://youtu.be/_kiP6q8DX5c The IRS agent confirmed everything about the 2.5 month rule that others have mentioned. She explained that under IRC Section 401(k)(8), if corrections are made within 2.5 months after the end of the plan year, the returned excess contributions are included in your income for the tax year in which the contributions were made. If corrected after that period, they're included in income for the year distributed. I was doubtful this service would actually work, but I got a callback from the IRS in about 35 minutes after trying to call on my own for days.

Following up on my skeptical comment - I have to admit I was completely wrong about Claimyr. After struggling with this exact 401(k) non-discrimination test issue and getting nowhere with the IRS phone line (hung up on twice after 30+ minute waits), I reluctantly tried the service. I got a call back with an actual IRS agent on the line in about 45 minutes. The agent walked me through exactly how the 2.5 month rule affects my returned excess contributions. She confirmed that since my plan administrator is making the correction in February 2025, the distribution is taxable in 2024 (when I made the contributions). She also explained that my 1099-R would have code "8" in Box 7 which specifically indicates an excess contribution correction. Honestly saved me hours of frustration and possibly filing incorrectly. Consider me a convert!

My company had this exact same issue a few years back. Something that nobody has mentioned yet - make sure your W-2 is correct! My company initially issued W-2s with the full contribution amount in Box 12 (with code D for 401k deferrals), then had to issue a corrected W-2 after the non-discrimination test failure. If your HR doesn't send a corrected W-2, your reported retirement contributions won't match what actually happened after the correction. This can create a real headache if you get audited later. Double-check that your W-2 reflects the reduced contribution amount after the excess is returned.

Quick question - does anyone know if the returned earnings portion of the excess contribution is subject to the 10% early withdrawal penalty if you're under 59½? My plan administrator told me it might be, but I'm getting conflicting information.

This is a really complex situation that trips up a lot of people! I went through something similar last year and want to add a few practical tips based on my experience: 1. Get everything in writing from HR - specifically the date they're processing the correction and confirmation about the W-2 correction that Zainab mentioned. My HR initially said "early 2025" which wasn't specific enough to determine if it fell within the 2.5 month window. 2. The 1099-R you receive will be key - it should have distribution code "8" in Box 7 for excess contributions returned due to failed ADP/ACP tests. Make sure to keep this with your tax records. 3. Don't forget that if you're getting earnings returned too (which is common), those earnings are taxable as ordinary income for the year being corrected (2024 if done by March 15, 2025). The earnings portion may also be subject to the 10% penalty if you're under 59½. 4. Consider talking to a tax professional if the amounts are significant. The interaction between the returned contributions, earnings, and how they affect your tax liability can get pretty complex, especially if you're near certain income thresholds for other tax benefits. The 2.5 month rule is real and it's specifically in the IRS regulations for 401(k) plan corrections. Your HR person is correct about the timing impact on which tax year is affected.