Top ten issues identified during examinations of IRC 401(k) plans.
1. Late Deposit of 401(k) Deferrals
Rules (DOL - CFR 2510.3-102) applicable to Internal Revenue Code (“Code”) section 401(k) plans require that the employer deposit salary deferrals as of the earliest date on which such amounts can reasonably be segregated from the employer's general assets. In most cases, the salary deferral amounts can be segregated within a day or two of the date the employee’s paycheck is issued. In many cases, amounts can be segregated on the same day.
Other rules provide that in no event may salary deferrals be deposited later than the 15th business day of the month following the month in which such amounts would otherwise have been payable to the participant in cash. Unfortunately, many employers have misinterpreted this rule, believing that it provides them with a “safe harbor” that allows them to delay deposit until the 15th business day of the following month, regardless of whether amounts can be segregated on an earlier date. In fact, this is not a safe harbor. Rather, it sets a maximum deadline for depositing contributions.
Employers need to implement procedures to ensure that salary deferrals are deposited timely. The failure to deposit salary deferrals on a timely basis constitutes a prohibited transaction subject to excise tax under section 4975 of the Code, payable by the employer with the filing of Form 5330. In addition to the payment of tax, the employer must correct the transaction. Correction requires the restoration of lost income resulting from the late deposit of amounts to the trust. Delaying the deposit of salary deferrals until after 12 months following the end of the plan year could result in plan disqualification.
2. Improper 401(k) Accelerated Deductions
Employers are improperly claiming a deduction on their current year federal income tax return that relates to 401(k) deferrals made on account of and paid during, the subsequent tax year. Revenue Ruling 2002-46 describes this acceleration of 401(k) deductions as a tax avoidance scheme, which constitutes a “listed transaction” for tax shelter purposes.
Employers should be wary of deduction or other schemes related to their 401(k) plans. Employers who have participated in this listed transaction should refer to Revenue Ruling 2002-46 for guidance in correcting the problem and Announcement 2002-2 for disclosure requirements. If the transaction is not corrected timely or disclosed properly, the employer may be liable for penalties (i.e. accuracy-related or fraud penalties) in addition to any income taxes due.
Employers are also improperly accelerating income tax deductions by contributing amounts in the current year (usually on the last day of the taxable year) that are attributable to subsequent year salary deferrals. The early contribution violates IT Reg. 1.401(k)-1(a)(3)(iii)(C) which provides that as a general rule, contributions are made pursuant to a cash or deferred election only if the contributions are made after the employee’s performance of service with respect to which the contributions are made (or when the cash or other taxable benefit would be available, if earlier). There is an exception for bona fide administration considerations only if the contributions are not paid early with a principal purpose of accelerating deductions.
3. Failure to Use Correct Compensation
Plan administrators are using the incorrect definition of compensation when calculating the Average Deferral Percentage (“ADP”) and Actual Contribution Percentage (“ACP”) tests; computing the salary deferral and employer matching contributions; and verifying that contribution limitations are satisfied. Usually, these problems occur when the employer and/or plan administrator are not aware that the plan document contains different definitions of compensation for different plan purposes. Plan administrators are also failing to limit compensation for contribution and nondiscrimination purposes as required under section 401(a)(17) of the Code.
Employers and plan administrators need to be familiar with the terms of the plan document to ensure that they use the proper definition of compensation for nondiscrimination testing, deferral and contribution calculations and limitation purposes. It is important to know whether (i) types of compensation are excluded for specific plan purposes, (ii) compensation is limited for specific plan purposes, and/or (iii) compensation is determined using different computation periods (i.e. plan year vs. calendar year). The failure to (i) follow the terms of the plan document, (ii) limit compensation under section 401(a)(17), and/or (iii) satisfy the ADP and/or ACP tests could result in plan disqualification.
4. Improper Exclusion of Eligible Employees for Purposes of ADP and/or
ACP Testing
When conducting the ADP and/or ACP tests, plan administrators are improperly excluding eligible employees.
For ADP purposes, eligible employees include all employees who are directly or indirectly eligible to make a cash or deferred election under the plan for all or a portion of the plan year. This means that an employee who can defer at any time during a plan year must be included in the testing, including part-time employees who satisfy the eligibility requirements. When conducting the ADP test, plan administrators are improperly excluding eligible part-time employees, non-deferring employees who begin or terminate participation during a plan year, and/or those employees who simply choose not to defer.
When conducting the ACP test, plan administrators are improperly excluding employees who are eligible under the plan to make employee contributions or to receive an allocation of matching contributions, but choose not to make employee contributions or do not receive any matching contributions.
Another problem occurs when the population of eligible employees is different for ADP and ACP testing purposes and the plan administrator does not differentiate when conducting the tests.
Example:
A plan provides that an employee is eligible to make deferrals for any portion of the plan year even if he or she terminates during the year with less than 500 hours of service. That employee must be included in the ADP test. The plan also provides that the same employee must be employed on the last day of the plan year in order to receive an employer matching contribution. If the employee is not employed on the last day of the plan year, the same employee would not be included in the ACP test.
Employers are ultimately responsible for ensuring that their plans operate in accordance with the rules set forth under sections 401(k) and 401(m) of the Code. Employers and/or plan administrators should implement procedures to ensure that administrators have sufficient employment and payroll records to identify all eligible employees and that these employees are properly included for purposes of ADP and/or ACP testing. The failure to follow the terms of the plan document or satisfy the ADP and/or ACP test could result in plan disqualification.
5. Misclassification of Highly and Non-highly Compensated Employees for
Purposes of ADP and/or ACP Testing
Plan administrators are misclassifying highly and non-highly compensated employees for purposes of ADP and ACP testing. Misclassification often occurs when the administrator fails to review prior year compensation, consider the attribution rules related to ownership when identifying 5% owners, and/or comply with the plan document in instances where it provides for the top-paid election. Problems result when there is a communication gap between the employer and plan administrator with respect to what the plan document provides and what documentation is needed to ensure compliance.
Employers should work with their plan administrators to ensure that (i) both parties are familiar with the terms of the plan, and (ii) plan administrators are provided with all of the information needed to make a proper determination of each employee’s status. The failure to follow the terms of the plan document or satisfy the ADP and/or ACP test could result in plan disqualification.
6. Failure to Correct or Timely-Correct ADP and/or ACP Failures
Plan administrators are failing to take timely, proper corrective action after finding that their plans fail the ADP and/or ACP test. In many cases, the plan administrator does not receive the information needed to conduct the tests in time to make needed correction.
Employers and/or plan administrators need to implement procedures to ensure that excess contributions and/or excess aggregate contributions are corrected in a timely manner. In general, if correction is not completed within 2 ½ months following the end of the plan year to which the excess deferrals relate, the employer will be liable for a 10% tax under section 4979 of the Code. (Note: The 10% tax will not apply if the employer uses the current year testing method and corrective QNECs or QMACs are made within the 12-month period following the testing year.) The failure to (i) follow the terms of the plan document (relating to correction), and (ii) satisfy the ADP and/or ACP tests could result in plan disqualification. Disqualification of the plan will apply not only for the plan year for which the excess contributions were made but will also include all subsequent plan years during which the excess contributions remain in the trust.
7. Incorrect Employer Matching Contributions
Employers are failing to contribute the employer matching contribution provided for under the terms of the plan document. In many cases, the problem is caused by the employer’s and/or plan administrator’s failure to properly count hours of service or identify plan entry dates for employees.
Incorrect contributions are also made when of the employer and/or plan administrator fails to follow the terms of the plan document. A common problem is the failure to use the definition of compensation described in the plan document. For example, the sponsor or administrator may not add deferrals back into compensation as required under the plan document when calculating the matching contribution.
Another problem has to do with the timing of matching contributions. The terms of a plan usually state that employer matching contributions will be a percentage of participant deferrals, up to a specified level. Plans generally describe these matching contributions in terms of annual amounts and percentages. If the plan administrator calculates the matching contribution on a payroll basis, rather than on an annual basis, at the end of the year the sum of these amounts may not comply with the terms of the plan.
Example:
A plan provides that the employer will make matching contributions based upon employee deferrals for the year and that the match will equal 50% of the amount deferred by the participant for the year. The maximum deferral considered for the matching contribution is 4% of compensation. A participant deferring at least 4% of compensation should have a matching contribution allocation of 2% of compensation. Participants are allowed to change their deferral levels at stated intervals during the year.
For administrative reasons, the match is computed and paid each pay period. If a participant elects a 2% rate of deferral for the first half of the year, the match per pay period would be 1%. If the participant elects a 6% rate of deferral for the second half of the year, the match per pay period would be 2% (only deferrals up to 4% of compensation are considered). The result would be deferrals for the year of 4% of compensation and matching contributions of 1.5% of compensation. This result comes from the administrative decision to compute the match periodically during the year rather than at the end of the year when total deferrals would be known. If the plan provisions state that matching contribution will be determined each payroll period, there is no operational problem. Otherwise, an additional contribution would be required at year-end to bring the participant's match up to 2%.
Employers and plan administrators need to be familiar with the terms of their plan and implement procedures to ensure that the plan operate in accordance with the plan document. Employers should work with plan administrators to ensure that the administrators have sufficient employment and payroll information to calculate the employer matching contribution described under the terms of the plan document. The failure to follow the terms of the plan document could result in plan disqualification.
8. Deferrals in Excess of Code Section 402(g) Limits
Employers are improperly allowing employees to defer compensation amounts in excess of the 402(g) dollar limitations. Common causes include the failure to monitor (i) limitations for each employee, (ii) limitations based on the calendar year, and (iii) employees who transfer between divisions/plans of the same employer.
In some cases the employer is not aware that the 402(g) limitations apply to the participant, rather than the plan. The employer establishes multiple plans and allows the participant to defer the maximum 402(g) amount under each plan.
In other cases, the plan year is other than the calendar year and deferrals are made based on plan year compensation. When testing for 402(g) compliance, the administrator bases the limitation on the plan year deferrals, rather than deferrals made during the calendar year.
Problems also occur when the employer and/or plan administrator fail to monitor employees who transfer between divisions and plans of the same employer and allow participants to defer the maximum 402(g) amount under each plan.
Employers need to ensure that they have a system in place to monitor salary deferrals for those employees who participate in more than one plan of the employer. Employers should work with plan administrators to ensure that the administrators have sufficient payroll information to verify that the deferral limitations of 402(g) were satisfied. Section 401(a)(30) of the Code provides that if excess deferrals are made to a plan and are not distributed along with related earnings before April 15 of the subsequent year, the plan will be disqualified.
9. Failure to Timely Provide the Safe Harbor Plan Notice
Plan sponsors are failing to timely-provide the required notice for safe harbor plans.
In order to satisfy the ADP safe harbor requirements, plan sponsors are required to provide participants with timely notice of the safe harbor provisions. The timing requirement requires that the plan sponsor must provide notice within a reasonable period before each year.
This requirement is deemed to be satisfied if the notice is given to each eligible employee at least 30 days and not more than 90 days before the beginning of each plan year (with special rules for employees who become eligible after such 90th day).
A plan that uses the 401(k) safe harbor matching contribution method will not fail to satisfy section 401(k) (or section 401(m)) for a plan year merely because the plan is amended during the plan year to reduce or eliminate matching contributions, provided that a supplemental notice is given to all eligible employees explaining the consequences of the amendment and informing them of the effective date of the reduction or elimination of matching contributions so that they have a reasonable opportunity (including a reasonable period) to change their cash or deferred elections and, if applicable, their employee contribution elections.
Employers and plan administrators need to understand the requirements for safe harbor plans and ensure that procedures are in place so that those requirements are satisfied in the plan document and plan operation. The failure to follow the terms of the plan document could result in plan disqualification.
10. Failure to Meet Hardship Distribution Requirements
In 401(k) plans that offer participant loans and hardship distributions, plan administrators are allowing hardship distributions to participants who elect not to take out a plan loan to satisfy the hardship. This fails to satisfy the hardship distribution rules that provide that a hardship distribution may not be made to the extent that the need may be satisfied from other resources that are reasonably available to the employee. (See I.T. Reg. section 1.401(k)-1(d)(2)(iii)(B).)
Another problem with respect to hardship distributions involves employers that fail to suspend salary deferrals for participants who receive hardship distributions from their accounts. The failure to suspend salary deferrals may occur as a result of a lack of communication between the employer and plan administrator regarding participants who have received a hardship distribution. The failure may also occur because the employer is not aware of the rules for hardship distributions or familiar with the plan document provision that requires the suspension. (See I.T. Reg. 1.401(k)-1(d) (2)(iv)(B).)
Employers need to be familiar with the hardship provisions included in their plan documents and implement procedures to ensure that the provisions are followed in operation. Employers need to ensure that the plan administrators and payroll offices share information regarding hardship distributions that are made from the plan. The failure to follow the terms of the plan document could result in plan disqualification.
If employers find that they have failed to satisfy the qualification requirements set forth for 401(k) plans, they may be eligible for relief under the IRS’s Employee Plans Compliance Resolution System (“EPCRS”) program. For more information on the EPCRS program, refer to Revenue Procedure 2008-50.
Reminder: Plans must be amended timely to comply with the final 401(k)/(m) regulations!!
In general, the 401(k)/(m) final regulations are effective for plan years beginning on or after 01/01/2006, and must be adopted by the later of (1) the due date of Employer's 2006 income tax return (plus extensions), or (2) the end of the plan year in which the provisions were first effective.
Note: Plan sponsors were permitted to apply the final regulations to any plan year ending after 12/29/2004, provided the plan applied all of the rules of the final regulations for the plan year and all subsequent plan years. In that case, adoption was required by the later of (1) 12/31/2005, or (2) the end of the plan year in which the provisions were first effective.
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