If you provide a 401(k) plan for your employees, you already know that your plan must comply with many detailed requirements from the IRS. This article is a synopsis of the twelve most common mistakes plan sponsors make in administering their plan, how you might fix it, and links to more detailed information from the IRS if you suspect you may be making one or more of these mistakes.

Mistake #1: Failing to Update Your Plan to Reflect Current Laws and Regulations

Upon demand, you must be able to produce timely-adopted written retirement plan documents and amendments you’ve made to reflect changes in the law.

If you haven’t updated the terms of your retirement plan in recent years, chances are you’ve missed many important updates. When was the last time you reviewed your plan for compliance with current law?

If it was more than a year ago, first, review the annual cumulative list to see if the plan has all required law changes. Beginning in 2016 and continuing to the present, here are the annual required amendments list.

Identify any discrepancies or omissions in your plan. Then, update all of your plan documents to reflect current law. These documents include:

• The original plan document;
• All subsequent plan amendments or restatements;
• Any adoption agreements (including a basic plan document providing details of how the plan must operate);
• Any IRS opinions or advisory letters you have received;
• Any IRS determination letters you have received;
• Your Board of Directors’ resolutions and minutes, or any similar records related to your plan.

Follow the deadlines listed here for your particular type of plan.

To avoid making this mistake in future years, calendar an annual review of your plan by a designated individual or team in your organization as the plan administrator or the plan administration team. Make sure all plan documents match and that all amendments are recorded and retained for inspection, if and when required. If you purchased your plan from a third party, contact them annually for updates.

Mistake #2: Failing to Follow the Terms of Your Plan

It is very common for an organization to purchase a pre-approved retirement plan from a third party, and then fail to follow the plan’s terms when administering the plan.

As part of your annual review, you should audit the administration of your plan to ensure that you comply with its terms. If you find a discrepancy, you must use a reasonable correction method that places affected plan participants in the same position they would have been had you not made the mistake.

Consult Revenue Procedure 2019-19, section 6 for general correction principles you should use to determine the appropriate correction. You have the option of self-correcting significant mistakes within two years, or if the mistake is insignificant, you have more than two years.

If your plan is not under audit, you can make a Voluntary Correction Program (VCP) submission to the IRS according to Revenue Procedure 2019-19, Section 11, via the Pay.gov website. Use the model documents in the Form 14568 series to resolve some common operational problems, or if those documents do not address your particular problem, use Form 14568 and descriptive narrative attachments.

If the IRS is auditing your plan, you and the IRS can enter into an agreement providing for the correction of the mistake and the negotiated sanction, which will be based on the particular circumstances of your situation.

Mistake #3: Misusing the Term “Compensation” as Defined in Your Plan

The term “compensation” can be problematic because it will have different definitions for different purposes, and can be easily misused. Compensation may be defined in any or all of these ways:

• Wages or salaries
• Other payments to an employee for professional services
• Other payments to an employee for personal services rendered, including, but not limited to, commissions, tips, and fringe benefits.         

You must follow the plan document compensation definitions. Your plan’s terms may include all or a portion of compensation for purposes of determining an employee’s allocation, salary reduction contribution, or elective deferral. For example, your plan might provide that “employees may defer up to 15% of their compensation…” You then have to go to the plan section containing definitions and find the “compensation” definition to determine what comprises “compensation” for this purpose. Does it include overtime? Tips? Commissions?

During your annual audit for compliance with new laws and the terms of the plan, review your compensation definitions to ensure that you are applying the term properly. If you find significant mistakes, you can self-correct with corrective contributions within two years. If you discover the mistake after two years, you must use the VCP and submit the model documents in the Form 14568 series. Insignificant mistakes can be corrected at any time.

Mistake #4: Failing to Match Employee Contributions According to the Terms of the Plan

This mistake is commonly made when an employer fails to use the term “compensation” properly and makes an error in calculating the employer’s matching contribution. When reviewing for proper use of the term “compensation,” also check to see that participating employees’ hours were calculated correctly for the purposes of the employer match.

Another common employer contribution error is in the timing of the employer contribution. For example, if the plan provides that your matching contribution is deposited monthly and you have been depositing contributions yearly, that is a mistake that must be corrected.

You must look for these mistakes in your annual audit, and if you find any, again, you must place participants in the same position as if you did not make the mistake. Contributions to correct significant errors may be made within two years. After two years, the VCP must be used. Insignificant errors may be rectified at any time.

To avoid this mistake in the future, work with your plan administrators to ensure that they have complete and current employment and payroll information for all participants so that they can then calculate the employer’s matching contribution per your plan document’s terms.

Mistake #5: Your Plan Does Not Satisfy the 401(k) ADP and ACP Nondiscrimination Tests

The nondiscrimination tests that assess the contributions made by non-highly compensated employees (NHCE) and by highly-compensated employees such as owners and managers (HCE) to your 401(k) plan are called the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests.

The ADP test looks at the elective deferrals (both pre-tax and Roth deferrals, but no catch-up contributions) of the HCEs and NHCEs. Dividing a participant’s elective deferrals by the participant’s compensation gives you that participant’s Actual Deferral Ratio (ADR). The average ADR for all eligible NHCEs (even those who chose not to defer) is the ADP for the NHCE group. Do the same for the HCEs to determine their ADP.

The ADP test is met if the ADP for the eligible HCEs doesn't exceed the greater of:

• 125% of the ADP for the group of NHCEs, or
• the lesser of:  
  • 200% of the ADP for the group of NHCEs, or
  • the ADP for the NHCEs plus 2%.

The ACP test divides each participant’s matching and after-tax contributions from the participant's compensation. The ACP test is met if the ACP for the eligible HCEs doesn't exceed the greater of:

• 125% of the ACP for the group of NHCEs, or
• the lesser of:  
  • 200% of the ACP for the group of NHCEs, or
  • the ACP for the NHCEs plus 2%.

During your annual audit, review the rules and definitions in your plan document for how to determine HCEs and how to calculate compensation, and procedures for ADP testing and ACP testing. Then run the tests.

If you find mistakes, again, place the affected participants in the position they would have been in had the mistake not been made. The terms of your plan will provide the correction method and statutory time limits. Again, self-correction may be used within two years of the expiration of the time period provided in your plan, or if more than two years have elapsed, you must use VCP.

Mistake #6: All Eligible Employees Are Not Given the Opportunity to Make an Elective Deferral

Plan sponsors often exclude eligible employees from making elective deferrals. Usually, this is a recordkeeping error or an error in applying the definition of “employee” for the purposes of the plan.

To find out if you’ve been making this mistake, first consult the plan for the definition of an eligible “employee.” The definition will be based on either hours or time of service. Then, make a list of all employees who received a W-2 and compare the number of hours worked or length of service to the eligibility requirements in your plan. Determine the date each employee was eligible to participate in the plan and inspect plan records to ensure that employees entered the plan timely and they were given the opportunity to make a deferral election.

Corrective contributions may be made by December 31 of the calendar year in which the mistake was made, otherwise, VCP must be used.

To avoid this mistake in the future, train your plan administrators to identify eligible employees, and establish protocols that, upon hire, a certain date or amount of hours worked will trigger a review of eligibility.

Mistake #7: Participants’ Elective Deferrals Exceed the IRC Section 402(g) Limits for the Calendar Year

Internal Revenue Code Section 402(g) limits the number of elective deferrals a plan participant may exclude from taxable income each calendar year, and that limit often changes annually. For example, in 2018 the limit was $18,500; in 2019, $19,000; in 2020, $19,500. (Full List of 2020 Contribution Limits)

Plan participants who are 50 and older may start making catch-up contributions in the calendar year they turn 50. These are also subject to an annual increase. In 2018 and 2019, the catch-up contribution limit was $6,000, and in 2020 it was increased to $6,500.

Your plan administrators should establish protocols that trigger an alert when a participant exceeds the annual contribution amount. If the limit is exceeded, to avoid the imposition of an additional 10% tax on that amount, correct excess deferrals no later than April 15 of the following year. If the error is discovered and/or corrected after that date, you may still correct it under EPCRS; however, it won't relieve your obligation to pay the Section 72(t) 10% tax.

Mistake #8: Failing to Timely Deposit Employee Elective Deferrals

The Department of Labor requires employers to deposit deferrals to the plan’s trust as soon as the employer can, and no later than the 15th business day in the following month. The DOL provides a 7-business-day safe harbor rule for employee contributions to plans with fewer than 100 participants.

If an employer fails to make the deposits timely, that may be both an operational mistake, giving rise to planning disqualification (if the plan specifies a date by which the employer must deposit elective deferrals), and a prohibited transaction. You can correct an operational mistake under EPCRS, and resolve a prohibited transaction through the DOL’s Voluntary Fiduciary Correction Program (VFCP).

To avoid making this mistake, payroll and the personnel administering the plan should coordinate efforts to find the earliest dates that deferrals may be deposited, and establish procedures by which deposits are timely made.

Mistake #9: Participant Loans Do Not Meet the Requirements of the Plan or IRC Section 72(p)

Loans in default or otherwise not meeting the requirements of the plan or IRC Section 72(p) may be treated as a taxable distribution to the participant borrower if not corrected.

A loan must meet several criteria under IRC Section 72(p) to prevent the law from treating it as a taxable distribution to the participant borrower:

1. The loan must be a legally enforceable agreement.

2. The amount of the loan can't be more than 50% of the participant’s vested account balance, up to a maximum of $50,000.

3. The loan terms should require the participant to make level amortized payments at least quarterly, specifying principal and interest.

4. Exceptions for leave of absence include suspension of repayment for up to one year, but cannot extend the maximum repayment period, and allow for additional payments to ensure repayment within the five-year period. Loan payments may be suspended for more than one year if the absence is due to military service, in which case the five-year loan term is extended by the length of military service.

During your annual audit of the plan, review each loan for compliance with these four criteria. If you find an error, your plan administrator must work with the participant-borrower to fix the mistake.

Mistake #10: Making Improper Hardship Distributions

An employee may take a hardship distribution from the company 401(k) in times of immediate and heavy financial hardship. The terms of the plan will provide how and when hardship distributions may occur, usually due to one of the following:

• Medical care expenses previously incurred by the employee or the employee’s immediate family:
• Costs directly related to the purchase of a principal residence for the employee (but not ongoing mortgage payments);
• Payment of post-secondary tuition, other educational fees, and room and board expenses for the next 12 months for the employee, the employee’s spouse, children or dependents;
• Payments to prevent the employee’s eviction or mortgage foreclosure;
• Funeral expenses for the employee’s deceased parent, spouse, or other family members; or
• Some expenses are needed to repair damage to the employee’s principal residence.

The employee must show not only one of the aforementioned circumstances but that the financial need can only be met with a distribution from the plan.

Your plan administrator should review the plan to determine whether hardship distributions are permitted and under what circumstances, and find out if any have been made. Those distributions should be reviewed for compliance with the terms of the plan.

If distributions are non-compliant, there are two ways to self-correct:

1. Have the employee return the distribution plus what that distribution should have earned, or;

2. Retroactively amend the terms of the plan to allow for the distributions that did occur.

The VCP program is also available.

Mistake #11: Failing to Make the Minimum Contributions when the Plan is Top-Heavy

A retirement plan is top-heavy when more than 60% of its assets are owned by key employees. Key employees are:

• An officer making over $185,000 for 2020; ($180,000 for 2019, $175,000 for 2018, and $170,000 for 2015 through 2017);
• An owner of 5% or more of the business;
• An employee owning more than 1% of the business and earning over $150,000 for the plan year.

All other employees are non-key employees. (Full List of 2020 Contribution Limits)

When a plan is top-heavy, an employer is required to contribute 3% of compensation of all non-key employees still employed on the last day of the plan year in question. This contribution is subject to vesting, requiring participants to be 100% vested after three years; or 20% after 2 years, 40% after 3, 60% after 4, 80% after 5, and 100% after 6 years.

To find out if you’ve made this mistake, first, identify all key employees. One or more may have escaped your attention due to periodic raises. Once key employees are identified you can review their contributions to the plan and calculate whether it is top-heavy.

An employer can self-correct by making the required contributions within two years. If the employer fails to self-correct within two years and the mistake is significant, they must use VCP.

To avoid this mistake in the future, the employer should include a top-heavy audit in the annual review of the plan.

Mistake #12: Failing to File the Annual Form 5500

Most 401(k) plan sponsors are required to file an annual Form 5500, which is the Annual Return/Report of Employee Benefit Plan. Learn how to file your Form 5500 return using the EFAST electronic filing system at www.efast.dol.gov.

Very small employers whose employees are limited to owners or partners and their spouses’ file Form 5500-EZ with the IRS instead, for any year in which plan assets exceed $250,000 ($100,000 for years prior to 2007).

To correct this mistake, an employer can respond to an IRS inquiry with the form and an explanation of why it was not filed, and the IRS may waive the penalty. If the IRS hasn’t assessed any penalties and the plan is subject to ERISA, the employer may use the Department of Labor’s Delinquent Filer Voluntary Correction Program (DFVC).

To avoid this mistake, the plan administrator should calendar the annual due date and be sure to prepare and file the appropriate form timely. For more information on filing Form 5500 see our dedicated blog post.

Most of these mistakes can be corrected without penalty and without contacting the IRS. If you suspect your plan is non-compliant for these or any other reason, you can get more detailed guidance on any one of these twelve topics and more at www.irs.gov/retirement, or contact Leading Retirement Solutions for assistance.

For more tips and information regarding retirement plans, contact us.

Connect with us on Facebook, LinkedIn, and Twitter!