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January 22, 2018

IRS Lists Eleven Major Mistakes for 401(k) Plans

To assist employers with plan compliance, the Internal Revenue Service (IRS) recently released information detailing common 401(k) plan mistakes. Why eleven and not ten. Well, it’s the government so don’t ask.

In this guidance, the IRS provides a summary of the eleven errors as well as information regarding how to identify each issue and correction methods to use.

1. Failing to Update the Plan

Plan document text (or as we refer to it plan “language”) should be reviewed annually and needs to be amended periodically to keep the plan within the law. The IRS demands that employers pay particular attention to updating plans to current law, as plans that are not current will encounter difficulties retaining qualified status. In other words, big penalties. A common misconception is that the “language” in the amendment “doesn’t seem to apply to me”. This may be true, however; the government looks at it in a different light. They say their rules could apply to you therefore the amendment is required.

2. Inconsistencies in Operation

The employer is ultimately responsible for keeping the plan in compliance; however, several people become involved with a plan document relying on its provisions to operate the plan in conjunction with the law: human resources, company CFO, plan trustee, investment provider, third party administrator (TPA) and financial advisor. When changes are made, plan service providers should be timely notified to ensure that plan administration remains consistent with plan documentation. Commercial: Always call Benefit Equity or your financial advisor and we will help with all notifications.

3. What is your Definition of “Compensation?”

Compensation is generally the amount of money paid to employees. Accurately applying a plan's stated definition of compensation is a key element to operating an error-free plan. A plan may contain different definitions of compensation for different plan purposes. Amounts may be considered “compensation” and be eligible for deferrals, but those same amounts may be excluded when calculating compensation for determining employer profit sharing contributions or for nondiscrimination testing.

There are items that may or may not be included in compensation; for example, the inclusion of expense reimbursements, car allowances, bonuses, commissions and overtime pay in compensation can vary from plan to plan. When an incorrect definition is used, the employer may have to make a corrective distribution of an excess deferral or make a corrective contribution to the plan, plus earnings. To limit errors, the person in charge of determining compensation (often at a payroll processing level) must be properly trained to understand the plan document and payroll codes should be coordinated with the definition of compensation.

The Internal Revenue Service under the Section 415 of the Internal Revenue Code provides limits on “annual additions” to defined contribution plans, including 401(k) plans. This rule explicitly addresses the includability in compensation of amounts paid after termination of employment. Employers who define compensation by reference to amounts reportable on Form W-2 will need to pay special heed to these regulations, as some amounts reportable on the Form W-2 of an employee for the year of his or her termination may not be includable in compensation for Section 415 purposes.

4. Missing Matching Contributions

Occasionally employers fail to credit the proper amount of matching contributions to a participant's account. Often this failure is due to administrative mistakes such as failing to properly count hours of service or identify plan entry dates for employees; not following plan language; or improperly computing compensation used as the basis for the match.

The timing of matching contributions can also lead to errors. For example, if a plan expresses the match formula on an annual basis but 401(k) contributions are actually matched on a per-payroll basis, some participants may not receive the full match to which they are entitled under the plan unless there is a year-end “true-up” to compare the actual matching contribution with what the match formula requires.

Matching contribution errors are minimized where plan administrators have knowledge of the match formula under the plan and have adequate and sufficient employment and payroll records to make correct calculations.

5. Failing Discrimination Testing

Unless a plan uses a safe harbor formula, it needs to be tested annually to determine whether the contributions made under the plan discriminate in favor of “highly compensated employees” (HCEs). These tests, the “actual deferral percentage” (ADP) test and the “actual contribution percentage” (ACP) test, assure that the amount of contributions made by and on behalf of non-“highly compensated employees” (NHCEs) are of a sufficient level in relation to contributions made by or on behalf of HCEs.

Plans often fail the ADP or ACP tests as a result of higher participation rates and greater deferral amounts by HCEs relative to those of the NHCE group. To guard against ADP or ACP test failure, employers may provide incentives for plan participation such as matching contributions, or use automatic enrollment or automatic increase features to enhance NHCE participation.

Plans can incorrectly perform the ADP and ACP tests when NHCEs and HCEs are improperly classified, not using correct compensation and eligibility definitions or the data used for the tests are incorrect.

When a plan fails either the ADP or ACP test, corrective action is required in to keep the plan qualified. Employers can choose to correct a testing failure by: (i) making additional qualified non-elective contributions (“QNECs”) on behalf of the NHCEs (if permitted under the plan); (ii) distributing excess 401(k) contributions to HCEs; and (iii) distributing excess vested matching contributions to HCEs (or forfeiting such excess contributions if not vested).

If a plan continually fails the ADP or ACP tests, the employer should consider having the HCE’s involved cut back their contributions or budget for a safe harbor plan, which relieves the testing obligation when certain stated contribution requirements are met. There are two safe harbor designs; one that requires the employer to give all eligible plan participants 3% of their compensation or a matching safe harbor. Matching only applies to those employees contributing to the 401(k) plan.

6. Un-Enrolled Eligible Employees

Eligible employees should be enrolled in the plan in a timely manner based on the plan's eligibility and participation requirements as stated in the plan document. Employees are often “missed” as a result of inaccurate employee payroll data, including date of birth, date of hire and number of number of hours worked. Failure to enroll an eligible employee can lead to missed opportunities for employee deferrals as well as missed opportunities for employer matching contributions or profit sharing contributions. Eligible employees who are not provided the opportunity to participate in the plan must receive a QNEC from the employer to the plan to compensate for the missed deferral opportunity.

Annual payroll audits and review of non-enrolled employees’ Forms W-2 can reveal “missed” eligible employees in an efficient manner, but some employers may need to review payroll records of non-enrolled employees during the plan year.

7. Not Properly Applying Plan Limits

Every plan must provide for certain limitations on employee contributions. The IRS places an annual limit on employee pre-tax deferrals ($18,500 for 2018), and, for those employees who are 50 years of age or older, a catch-up contribution limit ($6,000 for 2018) across all plans that in which an employee participates, regardless of the employer. A plan document will typically limit the percentage of pay that may be deferred. Operationally, plans may need to limit deferrals to pass nondiscrimination testing.

Where plan or the IRS limits are exceeded, the excess amount plus allocable earnings must be distributed to the participant by April 15 of the year following the year in which the error occurred and any amounts not returned to the participant are subject to additional taxation. To effectively administer contribution limits, employers should verify payroll information and communicate with employees who may participate in more than one 401(k) plan in a single calendar year, especially new employees hired other than as of January 1.

8. Delayed Payment of Deferrals and After-Tax Contributions to Plan

Employee pre-tax deferrals and after-tax contributions must be paid to the plan on the earliest date that the amount can be segregated from the employer's general assets. Often employers are waiting several weeks to forward the money. The Department of Labor (DOL) will make the employer reimburse plan participants for any loss of earnings. If they find the employer used the money inappropriately the employer, as Trustee, will be sued and removed as trustee. Close coordination among the employer, payroll processor and the recordkeeper is needed to assure that this requirement is met.

A late contribution gives rise to a prohibited transaction under the Employee Retirement Income Security Act (ERISA) between the plan and the employer, as the employer has retained “plan assets” in the general assets of the employer, a ”party in interest.” Earnings must be included when late employee deferrals are made to the plan and the prohibited transaction gives rise to an excise tax. Additionally, to the extent that the plan has language regarding the timing of deposits of elective deferrals, failure to follow the terms of the plan can result. Thus, this error may result in two corrections, using EPCRS to correct the operational fault of failing to follow the plan and VFCP for the prohibited transaction.

9. Testing a Top Heavy Plan

Some plans, particularly those sponsored by smaller employers, may need to perform a “top-heavy” test each year. This test ensures that lower-paid employees receive a minimum benefit if, during the previous year, the aggregate value of the plan accounts of “key employees” exceeds 60% of the aggregate value of the plan accounts of all employees under the plan.

Because the top heavy test focuses on the total value of accounts (not just contributions and deferrals made during the year), it is easier for small plans and plans with high turnover rates to be top-heavy. When a plan is top-heavy, an employer contribution of up to 3% of compensation must be made on behalf of all non-key employees still employed on the last day of the plan year. Employers and administrators should be aware that the definition of key employee is not the same as the definition of HCE and should be careful not to confuse the terms when performing required tests.

10. Assessing Hardship Distributions

Regulations under Section 401(k) of the Code provide “safe harbor” guidelines for plans that offer hardship distributions to participants. The regulations list events that can result in a participant's immediate and heavy financial need, thereby triggering a request for a hardship distribution. The distribution can only be in an amount necessary to satisfy the financial need, and a hardship distribution is not available where the need can be satisfied with money from other sources.

If a hardship distribution is made when the plan does not contain appropriate provisions, or where the facts and circumstances or documentation received does not support the amount of the distribution, a qualification defect arises requiring correction under EPCRS.

Employers should be familiar with the hardship provisions included in their plan document and should implement procedures to ensure that the provisions are followed in operation.

11. Keeping Up with Reporting Obligations

An employer has several, ongoing administrative duties related to the operation of a plan.

Foremost among these duties is to ensure that documents are kept up to date and, where appropriate, are filed with the federal government. Each year, employers must file a Form 5500 with the DOL. Fines for failure to file Form 5500 include both an IRS penalty ($25 per day, maximum of $15,000) and a DOL penalty ($2,000 per day, no maximum). The DFVC program offers a way to minimize penalties for late filing.

Also, employers must distribute a summary annual report (relating the plan's financial information) to participants on an annual basis. A summary plan description (“SPD”) must be distributed at the time of initial participation, redistributed periodically and must be provided upon request. When substantial changes are made to the plan, including changes to any information that is required to be in the SPD, a summary of material modifications must be issued to participants within 210 days after the end of the year in which the changes were adopted.

Plans that offer participant-directed investments must provide individual benefit statements at least quarterly (including required information regarding investment principles and limitations), while plans that do not permit participants to direct investment are required to provide benefit statements annually. In both cases, statements must be distributed within 45 days following the end of the applicable period. Statements must also be issued when a participant submits a written request (no more than one request in any 12-month period) and statements should automatically be provided to certain participants who have terminated service with the employer.

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Benefit Equity Summary and Comments

The complexity of qualified retirement plans requires employers to devote many hours of time and extensive company resources to plan administration. This is why employers rely upon a third party administrator such as Benefit Equity Inc to manage the plan. BEI addresses all of the above no less than annually to assure compliance.

Employers that “bundle” their plan administration and investments put themselves in a position of increased responsibility. In order to reduce costs those providers rely upon automation to make calculations and create reports. It is then incumbent upon employers to review the plan’s reports and operations to an even greater extent. The IRS didn’t just make up these eleven problem areas. They found that one or more of these issues are prevalent in most 401(k) plans.

Author: Robert Gorelick, APA, Founder Benefit Equity Inc.

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