Administering 401(k)s and similar retirement plans is complex, and the process offers many opportunities to make mistakes, such as:
- Not depositing participant deferrals or employer-matching contributions into employee accounts in a timely manner or in the correct amounts.
- Not vesting employees in matching contributions within the required time frame if the plan requires that employees remain at the organization for a length of time before they are vested in their employer's matching contributions.
- Excluding eligible employees from the plan and enrolling ineligible employees.
Making a mistake does not have to be a calamity—as long as employers and their plan vendors are vigilant and catch problems early. If left unchecked, however, retirement plan mistakes can be costly and inconvenient for both the employer and participating employees.
The Snowball Effect
An employer's annual matching or profit sharing contributions are usually based on an employee's compensation. But the calculations can be thrown off by using an employee's total compensation rather than the compensation designated in retirement plan documents, which are usually specific about what compensation can be used and may exclude, for instance, bonus payments.
When mistakes happen, "the financial impact can grow exponentially as the resulting problems build over time," said Chris Shankle, managing director with Argent Retirement Plan Advisors in Shreveport, La.
Problems can also snowball when errors occur with 401(k) plan nondiscrimination tests, which ensure plans don't favor highly compensated employees (HCEs) who earn more than an annual cap set by the IRS. For the 2020 plan year, an employee who earns more than $125,000 in 2019 is an HCE.
To keep its qualified status under IRS rules and the Employee Retirement Income Security Act, a 401(k) plan must pass the actual deferral percentage and actual contribution percentage tests, which compare plan participation rates among HCEs and non-HCEs.
If an employer is using the wrong compensation data to conduct nondiscrimination testing, it could end up with incorrect results. If the employer then uses these wrong results to return additional contributions to ensure that the plan is nondiscriminatory, participants may not receive the correct amounts. "Now you have another problem with a distribution from the plan that is not authorized by the plan document and jeopardizes the overall qualification of the plan," Shankle said.
An IRS webpage details how to correct nondiscrimination test errors.
Employers face additional jeopardy if the IRS or U.S. Department of Labor (DOL) discovers mistakes before the plan sponsor does. "A lot of plan sponsors think their plans are too small to get attention, but plan audits can occur randomly, or they can be triggered when someone, like a plan participant, files a complaint," said Carol Buckmann, a partner with law firm Cohen & Buckmann PC in New York City.
In other cases, the information provided in the retirement plan's annual Form 5500 can trigger an audit, or a plan audit could simply occur as part of a broader company audit.
[SHRM members-only toolkit: Designing and Administering Defined Contribution Retirement Plans]
Keep an Eye Out
Employers that identify retirement plan mistakes on their own can remedy these issues to avoid problems later. The following resources are available to employers that need to get their plans back on track:
- The IRS's Employee Plans Compliance Resolution System (EPCRS) helps fix operational mistakes, such as common errors involving contributions or deposits into participants' accounts, and mistakes with participant loans.
Expanded Self-Correction Options
The IRS Employer Plans Compliance Resolution System is comprised of three programs:
- Self-Correction Program (SCP) for correcting certain operational or document failures and documenting the correction in a memorandum. Significant errors must generally be corrected by the last day of the second plan year after the year in which the mistake happened.
- Voluntary Correction Program (VCP), which requires filing an application and paying a fee to seek IRS approval of the correction, and is used to correct a broader range of failures than SCP, including significant failures not corrected within SCP's required time period.
- Audit Closing Agreement Program (Audit CAP), which applies to plans under examination. Audit CAP involves taking IRS-approved corrective actions, paying a negotiated penalty and entering a closing agreement with the IRS.
IRS Revenue Procedure 2019-19, which took effect in April, updated the EPCRS system by streamlining its correction procedures and allowing for more self-correction options, particularly for participant loan defects, and by allowing more situations to be corrected with plan amendments.
"The IRS has rightly concluded that an expansion of the self-correction process will promote voluntary compliance for retirement plans and reduce the costs and burdens of compliance on employers," wrote Christopher Lockman, an attorney with law firm Verrill Dana LLP in Portland, Maine.
Putting It Right
"Errors and compliance problems found by the employer have many more options for correction and generally are significantly less expensive to correct," Shankle said.
In many cases, a plan sponsor can correct mistakes using EPCRS's self-correction program without contacting the IRS or paying a fee. "If the mistake is insignificant, it can be corrected at any time to preserve the tax-favored status of the plan," said Bill Zorc, a manager with accounting firm Marcum LLP in Deerfield, Ill. Employers can rectify significant mistakes on their own as long as they do so before the end of the second plan year after the error occurred.
Just fixing the plan may not be enough. If there is an operational violation that harms the employees participating in the plan, the employer must take steps to make the plan and its participants whole, as if the problem never happened.
For example, if an employer finds that participant payroll deferrals or employer contributions are not being deposited in employees' accounts, the employer must take steps to make sure the appropriate amounts are deposited and credited to each participant's account. The employer must also then make up for any lost investment earnings caused by the delayed deposits, Buckmann said.
The employer must also identify and locate employees who have left the organization but were affected by the problem, to ensure that they're also made whole for lost growth in their accounts.
And there's yet another reason employers should act quickly to remedy retirement plan mistakes: Once the IRS or DOL gets involved, "the avenues available for employers to self-correct become severely limited," Shankle said. "This increases the cost of the ultimate correction and exposes the plan sponsor to what can be significant sanctions on top of the correction cost."
Make Sure It Doesn't Happen Again
After an employer addresses any problems, it should document everything it did. "I recommend writing a memo that explains the situation and steps taken to fix the error, and [includes] documentation showing it has been rectified," said Wendy McSheffrey, a CPA with Edelstein & Company LLP in Boston. "This should be kept on file in case there is a DOL audit [of the plan] in the future."
Of course, fixing mistakes is just the start of this process. Employers should also consider taking steps to ensure mistakes don't happen in the future. "The IRS has begun to consider employers' overall internal control systems, practices and procedures," Shankle said. "They want to assess the likelihood of compliance problems and where those problems might occur within the plan's administration."
Employers can use the IRS plan checklist as a starting point to avoid future mistakes.
Joanne Sammer is a New Jersey-based business and financial writer.
Related SHRM Articles:
IRS Updates Correction Program for Retirement Plans, SHRM Online, April 2019
IRS Offers No Fee Relief for Correcting Retirement Plan Errors, SHRM Online, January 2019
IRS Retirement Plan Corrections Are Going Paperless, SHRM Online, October 2018