This is the third and final installment in a series of articles discussing some of the common compliance issues encountered by the Internal Revenue Service (AIRS@) during its examination and audit of tax-qualified retirement plans. The first two installments of this discussion were previously featured on this website.
The retirement plan industry is a technical and sophisticated one that is highly regulated by the IRS, among other government agencies. Due to the tangled web of rules that must be satisfied by the plan sponsor of a tax-qualified retirement plan, compliant operation of such a plan is a challenge even for a careful and experienced plan sponsor. Therefore, in the interest of assisting plan sponsors and other retirement plan professionals with avoiding operational violations of the tax-qualification rules regulating retirement plans, the following discusses several common errors identified by the IRS during retirement plan audits and examinations.
Incorrect Employer Matching Contributions
Employers may fail to accurately contribute the employer matching contribution provided for under the terms of the plan document. In many cases, the problem is caused by the employer’s or plan administrator’s failure to properly count hours of service or identify plan entry dates for employees. Incorrect contributions also may be made when the employer or plan administrator fails to follow the terms of the plan document. Another common problem is the failure to use the definition of compensation elected in the plan document. For example, the sponsor or administrator may not add deferrals back into compensation as required under the plan document when calculating the matching contribution.
Another problem has to do with the timing of matching contributions. The terms of a plan usually state that employer matching contributions will be a percentage of participant deferrals, up to a specified level. Plans generally describe these matching contributions in terms of annual amounts and percentages. If the plan administrator calculates the matching contribution on a payroll basis, rather than on an annual basis, at the end of the year the sum of these amounts may not comply with the terms of the plan.
For example, let us assume that a plan provides that the employer will make matching contributions based upon employee deferrals for the year and that the match will equal 50% of the amount deferred by the participant for the year. The maximum deferral considered for the matching contribution is 4% of compensation. A participant deferring at least 4% of compensation should have a matching contribution allocation of 2% of compensation. Participants are also allowed to change their deferral elections at stated intervals during the year.
For administrative reasons, the match is computed and paid each pay period. If a participant elects a 2% rate of deferral for the first half of the year, the match per pay period would be 1%. If the participant elects a 6% rate of deferral for the second half of the year, the match per pay period would be 2% (only deferrals up to 4% of compensation are considered). The result would be deferrals for the year of 4% of compensation and matching contributions of 1.5% of compensation. This result comes from the administrative decision to compute the match periodically during the year rather than at the end of the year when total deferrals would be known. If the plan provisions state that matching contributions will be determined each payroll period, there is no operational problem. Otherwise, an additional contribution may be required at year-end to bring the participant’s match up to the requisite 2%.
Employers and plan administrators should be familiar with the terms of their plan and implement procedures to ensure that the plan operates in accordance with the plan document. Employers should work with plan administrators to ensure that the administrators have sufficient employment and payroll information to calculate the employer matching contribution described under the terms of the plan document. Failure to follow the terms of the plan document could result in plan disqualification.
Failure to Timely Provide 401(k) Safe Harbor Notices
One of the requirements that must be satisfied in order to qualify as a “401(k) Safe Harbor” plan is for an employer to provide eligible employees an annual notification describing the benefits of the safe harbor plan. Such notice must be provided within a “reasonable” period before the beginning of each plan year (or in the year an employee becomes eligible, within a reasonable period before the employee becomes eligible). In general, the law considers notices to be timely if the employer gives them to employees at least 30 days (and no more than 90 days) before the beginning of each plan year.
Some employers fail to provide the necessary notice in accordance with the timing rules set forth above. Although the IRS has intimated that it intends to include “pre-approved” guidance on how to correct this failure within the next update to the “Employee Plans Compliance Resolution System” (“EPCRS”), a voluntary correction program sponsored by the IRS that may be employed to resolve certain operational tax-qualification defects; no formal guidance exists on how to resolve this failure. Notwithstanding, the IRS has informally indicated that several potentially proper voluntary “safe harbor notice failure” correction procedures exist. The informally recommended corrections range from simply reviewing existing procedures in order to attempt to ensure that the failure is not repeated to employer funded contributions for the benefit of participants who did not receive the proper notice.
Employers and plan administrators need to understand the requirements for safe harbor plans and ensure that procedures are in place so that those requirements are satisfied in operation. Failure to follow the terms of the plan document can result in plan disqualification.
Deferrals in Excess of Code Limits
Some employers improperly allow employees to defer compensation in excess of the maximum amount set forth under section 402(g) of the Internal Revenue Code of 1986, as amended (“Code”). Common causes of this problem include the failure to properly monitor limitations for each employee, the failure to apply the limitations on a calendar year basis, and the failure to accurately account for employees who transfer between divisions or plans of the same employer.
For example, in the situation where an employer is not aware that this limitation applies on a participant basis as opposed to a plan basis, such employer might establish multiple plans and allow the participant to impermissibly defer the maximum amount under each plan. In other cases where the plan year does not coincide with the calendar year, the employer or administrator may apply the limitation to the deferrals made during the plan year rather than to the deferrals made during the calendar year.
Employers should ensure that a procedure is in place to monitor salary deferrals for those employees who participate in more than one plan of the employer.
Employers should also work with plan administrators to ensure that the administrators have sufficient payroll information in order to verify that the deferral limitations of the Code are satisfied. The Code provides that excess deferrals and related earnings must be distributed before April 15 of the year after the year to which the deferrals relate or the plan at issue can be disqualified.
Failure to Meet Hardship Distribution Requirements
In general, a hardship distribution is permitted only to the extent that the financial need created by the hardship may not be satisfied from other resources that are reasonably available to the employee. Therefore, with regard to a plan that offers both participant loans and hardship distributions, a plan administrator should not permit a hardship distribution if a plan loan is available to satisfy the hardship. However, some plan administrators fail to enforce this requirement.
Another problem with respect to hardship distributions involves employers that fail to suspend salary deferrals for participants who receive hardship distributions from their accounts. The failure to suspend salary deferrals may occur as a result of a lack of communication between the employer and plan administrator regarding participants who have received a hardship distribution. The failure may also occur because the employer is not aware of the rules for hardship distributions or familiar with the plan document provision that requires the suspension.
Employers should be familiar with the hardship provisions included in their plan document and implement procedures to ensure that the provisions are followed in operation. Employers need to ensure that plan administrators and payroll offices share information regarding hardship distributions that are made from the plan. Failure to follow the terms of the plan document can result in plan disqualification.
If you think the discussion above potentially applies to your company or you are a retirement plan service provider with a client to whom these issuers may apply, please contact ExpertPlan Consulting Services as we can provide the assistance necessary to properly investigate and rectify these issues.