A typical defined contribution plan, such as a 401(k) or 403(b), consists of a deferred compensation component, with or without an employer match, and/or a profit-sharing component. Participants in one of these plans elect a percentage or a specific dollar amount to be withheld each pay period. The plan sponsor (the employer) then remits the funds, along with any employer contributions, to the plan’s trust account maintained by a trustee or custodian.
Issues can arise during every step of this seemingly routine transaction. Errors can be the result of one-time circumstances or can be systemic in nature. The issues discussed here are among the more common, though this certainly is not a complete list.
A popular feature in defined contribution plans is auto-enrollment or auto-escalation. In these situations new hires are automatically enrolled in a plan with a set deferral percentage or amount, and these amounts can automatically increase each year. A one-time error in this case would be if a new hire was not being enrolled in the plan due to the hiring manager being on vacation when the person starts. IRS Revenue Procedure 2015-28 explains the specifics of new safe-harbor correcting methods for these types of errors. Depending on the timing of when a mistake is caught, corrective contributions might or might not be required. In addition, to take advantage of these safe-harbor rules, corrective contributions pertaining to missed matching contributions and lost earnings must be made.
A systemic error can occur when a plan is on a noncalendar year and participant activity, such as deferrals, are not tracked as they should be to ensure that IRS annual maximum deferral amounts aren’t exceeded. If controls are not put in place or are ineffective, participants could end up with excess deferrals within the calendar year. As a result, corrective distributions are made to the participants, which must be reported as taxable income in both the year of deferral and the year of distribution. Put another way, if the distributions aren’t made until after April 15 of the following year, then participants will be double taxed because of this oversight.
Errors can also arise due to noncompliance with the plan document (operational errors). For example, participants in Plan A receive an employer match of 100 percent of their elective contribution, up to 5 percent of eligible compensation. Upon inspection of the plan document, it is discovered that the match should be based on 7 percent of compensation. In this situation, the employer may use the IRS Self Correction Program (SCP) to address the error, assuming certain eligibility requirements are met. Depending on the dollar amount of the errors, there could be a two-year time limit to enact the provisions of the SCP. If the amount is significant in the aggregate and the corrections are not enacted within two years, the employer would have to correct under the Voluntary Correction Program, which is the same method as the SCP but carries fees and must be carried out in accordance with IRS Revenue Procedure 2013-12. Finally, if the error was caught while under IRS audit, the Audit Closing Agreement Program is available, in which the employer and the IRS negotiate a sanction. All three of these programs fall under the IRS’s Employee Plans Compliance Resolution System.
Other common errors pertaining to defined contribution plans include issues with the definition of eligible compensation, loans being made that are not in accordance with the plan document, and payroll errors that result in incorrect calculations of participants’ deferrals and employer contributions. The IRS has a great tool on its website (www.irs.gov) called Fix-It Guides to help navigate through these issues.
The U.S. Department of Labor also has its own correction methods, including its Voluntary Fiduciary Correction Program. This program is open to anyone who may be liable for fiduciary violations under the Employee Retirement Income Security Act (ERISA). These types of violations can include the issues noted above, but also pertain to party-in-interest transactions. An example of this would be a business taking a loan from its own plan, which is a prohibited transaction.
It is critical that any issues that arise be dealt with immediately. The worst possible outcome would be for a plan to be deemed nonqualified and lose its tax-exempt status. When this happens, there are negative consequences to the participants, the employer, and the trust holding the assets. Any vested employer contributions become taxable income upon loss of the tax status. Participants are unable to make rollovers to eligible plans as any distributions from a nonqualified plan are fully taxable. The employer cannot immediately deduct its contributions to the plan while it is nonqualified. Finally, the trust holding the assets becomes a taxable entity and will be subject to income tax on any earnings.
The benefits of these voluntary compliance programs become clear when faced with the possible repercussions. When in doubt regarding the magnitude of an error, it is best to consult with an ERISA attorney.
Brian J. Weldin, CPA, is manager of assurance in the Lehigh Valley and Philadelphia offices of Baker Tilly Virchow Krause LLP. He can be reached at firstname.lastname@example.org.