Mistakes happen. But in the 401(k) plan context, mistakes can result in costly and time-consuming corrections or even risk a plan’s tax-favored status.
To avoid these problems, employers sponsoring 401(k) plans and their legal counsel should work together to prevent plan errors. Below are some best practices for employers administering 401(k) plans.
Make sure there are clear lines of responsibility for maintaining the plan document.
The plan recordkeeper may have agreed to make amendments necessary to comply with legal changes, but it is likely the employer’s responsibility to ask for timely updates when discretionary changes are made.
Conduct regular audits of plan administration.
Audit the plan operations on a regular basis to avoid inconsistency between the plan document and actual administrative practices. The areas where 401(k) plan sponsors typically have hiccups include:
- Failing to allow eligible employees to participate (or failing to notify them that they are eligible so that they have an effective opportunity to participate);
- Allowing ineligible employees to participate;
- Using the wrong definition of “compensation” (for example, forgetting to permit 401(k) deferrals from bonuses when the plan defines “compensation” to include bonuses) or coding payroll entries inconsistently with the plan’s “compensation” definition; and
- Failing to satisfy the plan’s requirements for hardship distributions.
In addition to regular audits, companies should work to avoid these errors by monitoring census information, training new personnel hired to work on the plan and carefully examining updated administrative procedures when there is a change in recordkeeping systems.
Timely perform nondiscrimination tests so that appropriate corrections may be made.
401(k) plans that do not have a “safe harbor” design must satisfy annual ADP and ACP nondiscrimination tests intended to ensure that the amount of contributions made by and for non-highly compensated employees are proportional to the contributions made by and for highly compensated employees.
While the testing itself is likely performed by the plan’s recordkeeper or another third party, the testing data should be reviewed to ensure that highly and non-highly compensated employees are properly classified and that the calculations are correct. If the plan fails these tests for a plan year, corrections will be required by either refunding contributions to highly compensated employees or making additional contributions to non-highly compensated employees by the end of the following plan. Ideally, these corrections should be made within the first 2½ months of the correction period to avoid paying an excise tax.
Consider simplifying your plan’s loan policy to avoid failures to comply with its terms.
If the 401(k) plan permits loans to be taken by participants, the plan should have a loan policy, which may be incorporated into the plan document or summary plan description or may be a stand-alone policy. The loan policy should be designed to satisfy Department of Labor guidance so that plan loans do not constitute prohibited transactions by requiring that loans, among other things, be available on a reasonably equivalent basis, bear a reasonable rate of interest and be adequately secured.
The loan policy also should be designed to satisfy certain Internal Revenue Code requirements so that the plan loans will not be treated as taxable distributions. For example, the loan policy should require that a loan be evidenced by a legally enforceable agreement, that loans be limited to a specific amount, and that loans be repaid within a certain time period. While it is important to have a loan policy in place that sets forth the applicable legal requirements, it is equally important that the loan policy be followed in the actual administration of plan loans. If the plan loan policy includes provisions that have been difficult to administer – for example, a high number of permitted loans or not allowing a grace period for late payments – the plan sponsor should consider modifications that would simplify its administrative procedures.
Work with the payroll provider to ensure that procedures are in place to make timely 401(k) deposits.
DOL regulations generally require participant contributions and loan repayments to be submitted to the plan’s trust as soon as the money reasonably can be segregated from the employer’s assets – subject to a safe harbor, seven-business-day deadline for small plans with fewer than 100 participants. A failure to make timely deposits is considered by the Internal Revenue Service to be a “prohibited transaction” under which the employer has impermissibly loaned itself the deposits during the period that the amounts should have been segregated.
The plan sponsor should monitor the process used by its payroll department or payroll provider to ensure that deposits are timely made and so that, if a deposit is not timely made, it can be corrected quickly.
Use calendar reminders to ensure that required filings and participant communications are provided as required.
401(k) plans are required to file a Form 5500-series return each year with the DOL. Plan sponsors and administrators also are required to provide various communications to participants; such communications include summary plan descriptions, summary annual reports, safe harbor notices if the plan is a safe harbor 401(k) plan and, for participant-directed 401(k) plans, annual fee disclosure notices and quarterly statements.
The timing rules for each required filing and participant communication differ, so it is important to have procedures such as calendar reminders in place to ensure that filings and communications are provided in a timely manner.
Mistakes are common, and both the IRS and DOL have correction programs in place.
The worst thing to do when a mistake is discovered is to ignore it. Instead, companies and legal counsel should determine the appropriate correction and fix the mistake. This will avoid potentially more costly corrections down the road in an audit situation.
Jessica Morrison is a tax partner in the Fort Worth office of Thompson & Knight LLP, specializing in employee benefits and executive compensation.