An HCE payment is a refund your 401(k) plan sends back to you because the plan failed the IRS’s annual fairness test for highly compensated employees. Your contributions were legal when you made them, but once the plan administrator ran the year-end nondiscrimination testing, the numbers came out lopsided in favor of higher earners, and the fix was to return some of what you deferred, plus or minus any investment earnings on that amount. You owe ordinary income tax on the refund, but not the 10% early withdrawal penalty.
Why You Got the Refund
Traditional 401(k) plans have to pass two IRS tests every year that compare how much highly compensated employees are contributing against how much everyone else is contributing. One test looks at salary deferrals (the Actual Deferral Percentage test), and the other looks at employer matching and after-tax employee contributions (the Actual Contribution Percentage test).1Internal Revenue Service. 401(k) Plan Fix-It Guide – The Plan Failed the 401(k) ADP and ACP Nondiscrimination Tests
When the gap between the two groups grows too wide, the IRS treats the plan as discriminatory. To keep its tax-qualified status, the plan has to either put more money into non-HCE accounts or pull money back out of HCE accounts. The refund landing in your bank account is the second option in action.
This is almost always a participation problem, not something you did wrong. If rank-and-file employees at your company aren’t contributing much, the average they set is low, and the ceiling for what highly compensated employees can collectively defer drops with it. You can be well under the individual 401(k) contribution limit and still trigger a failed test.
Whether You Actually Count as a Highly Compensated Employee
The IRS uses two tests under Internal Revenue Code Section 414(q). You only need to meet one.
The ownership test catches anyone who owned more than 5% of the business at any point during the current year or the prior year. Salary is irrelevant here; a low-paid owner still qualifies.
The compensation test catches anyone who earned more than a set dollar amount from the employer in the prior year. For the 2026 plan year, that threshold is $160,000, based on 2025 compensation. The same figure applied for the 2025 plan year. For earlier reference, the limit was $155,000 for 2024 and $150,000 for 2023.2Internal Revenue Service. COLA Increases for Dollar Limitations on Benefits and Contributions
One wrinkle: employers can elect a “top-paid group” option that narrows the compensation test to employees who both exceed the dollar threshold and rank in the top 20% of earners.3Internal Revenue Service. Identifying Highly Compensated Employees in an Initial or Short Plan Year That’s why some people who earn well above $160,000 never get an HCE refund; their employer’s plan design excludes them from the HCE group.
How the Refund Is Taxed
The tax treatment depends on whether the excess money was in your traditional (pre-tax) 401(k) or your Roth 401(k) bucket.
If the Contributions Were Pre-Tax
The full refund is taxable as ordinary income in the year you receive it, both the returned contributions and the investment earnings that came with them. You originally deducted this money from your taxable income, so the IRS is reversing the deduction. Your plan administrator will issue a Form 1099-R showing the distribution.4Internal Revenue Service. Instructions for Forms 1099-R and 5498
If the Contributions Were Roth
You already paid tax on the contributions themselves, so the returned principal isn’t taxed again. But any investment earnings paid out with the refund are taxable as ordinary income for the year you receive them.
No 10% Early Withdrawal Penalty
The 10% additional tax that normally applies when you take money out of a retirement account before age 59½ does not apply to a timely corrective distribution. The statute exempts these payments from the Section 72(t) penalty,5Office of the Law Revision Counsel. 26 USC 401 and the IRS lists corrective distributions of excess contributions and excess aggregate contributions among the recognized exceptions.6Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions You owe regular income tax; you don’t owe the extra 10%.
How the Amount You Got Was Calculated
Plan administrators don’t divide the excess evenly across everyone in the HCE group. They start with whoever had the highest deferral percentage and cut that person’s contributions down to match the next-highest person’s rate. Then they level again, and again, working downward until the plan’s overall averages fall within the legal limits.5Office of the Law Revision Counsel. 26 USC 401 The people who saved the most aggressively take the biggest refunds. Some highly compensated employees end up getting nothing back at all.
The final check also includes allocable investment income, meaning gains or losses that the excess money earned while it was in your account. A strong market year makes the refund a bit larger than the raw over-contribution. A down year makes it smaller. Either way, your remaining balance reflects only what the plan is legally allowed to hold for you.
One detail that surprises people age 50 and older: catch-up contributions aren’t included in the testing calculation. If you’re 52 and put in the full $24,500 regular limit plus $8,000 in catch-up for 2026, only the $24,500 is on the table when the plan tests for compliance.1Internal Revenue Service. 401(k) Plan Fix-It Guide – The Plan Failed the 401(k) ADP and ACP Nondiscrimination Tests
What to Do When the Payment Arrives
You can’t refuse a corrective distribution, and you can’t roll it into an IRA or another retirement plan. The money has to leave the 401(k), so your job is to handle it cleanly on your taxes and, if possible, put it back to work in a tax-advantaged account.
Check your Form 1099-R. Box 7 should carry a distribution code identifying this as a corrective distribution, commonly “8” or “P.”7Internal Revenue Service. Corrective Distribution of Excess Contributions If a different code appears, contact your plan administrator before you file your return. The wrong code can trigger an erroneous 10% penalty assessment from the IRS.
If you have room under the annual IRA contribution limit ($7,500 for 2026), consider putting the after-tax proceeds into a traditional or Roth IRA for the same year.8Internal Revenue Service. 401(k) Limit Increases to $24,500 for 2026, IRA Limit Increases to $7,500 That doesn’t undo the tax hit on the refund itself, but it keeps the money growing in a sheltered account instead of a checking account.
How to Stop This From Happening Every Year
If you’re getting an HCE refund annually, the plan has a structural problem, and no amount of personal budgeting will fix it. Two plan design changes can.
The first is a qualified nonelective contribution. Instead of pulling money out of highly compensated accounts, the employer puts additional money into non-HCE accounts, which raises the non-HCE average and lets the plan pass its tests. These contributions must be fully vested immediately.
The second is a safe harbor 401(k). A safe harbor plan is automatically deemed to pass the ADP and ACP tests, so no annual testing is required and no HCE refunds go out. In exchange, the employer commits to a mandatory contribution formula (a set match or a flat contribution for every eligible employee).9Internal Revenue Service. Notice Requirement for a Safe Harbor 401(k) or 401(m) Plan
If refunds keep landing in your account each spring, it’s worth raising the safe harbor question with your HR or benefits team. In the meantime, redirect the savings you can’t fit into the 401(k) toward a traditional or Roth IRA, a backdoor Roth strategy if your income is too high for a direct Roth contribution, or a taxable brokerage account. That way the money stays invested instead of cycling in and out of the plan.