May 29, 2009
James R. Griffin
Jackson Walker L.L.P.
901 Main Street, Suite 6000
Dallas, Texas 75202
jgriffin@jw.com •
214.953.5827
TOP 10 401(K) ERRORS AND
HOW THE IRS WANTS YOU
TO FIX THEM
Legal Requirement and Reality of
Errors
• 401(k) Plans must be tax-qualified:
– In Form
– In Operation
Adverse Consequences of
Disqualification
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Tax penalties
Litigation by participants
Violate loan covenants
Lose creditor protection
Impermissible plan investments
Violate Federal securities laws
Withhold audit report for Form 5500
Highlights of E.P.C.R.S.
Revenue Ruling 2008-50
www.irs.gov
• Correction Principles
• Categories of Qualification Failures
• Specific Programs
Correction Principles
• Full Correction—All Years
• Restore All Benefits
• Reasonable and Appropriate
Categories of Qualification Failures
• Plan Document Failure
• Operational Failure
• Demographic Failure
• Employer Eligibility Falure
Specific Programs
• Self-Correction Program—SCP
• Voluntary Correction With Service
Approval—VCP
• Audit Closing Agreement Program—Audit
Cap
Self-Correction Program—SCP
Insignificant Failures
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No reporting to IRS
No penalty
Available during IRS audit
No deadline
Established practices and procedures
(formal or informal) reasonably designed
to promote and facilitate overall plan
compliance
• Not available for egregious failures
Self-Correction Program—SCP
Significant Failures
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No reporting to IRS
No penalty
Not available during IRS audit
Must be corrected with 2 years after the plan
year in which the failure occurred
• Established practices and procedures (formal or
informal) reasonably designed to promote and
facilitate overall plan compliance
• Not available for egregious failures
• Plan must have determination letter or opinion
letter
Voluntary Correction With Service
Approval—VCP
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Filing with IRS is required
Payment of fee is required
Not available if plan is under examination
Available for late amendments
VCP User Fee
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Number of Participants
Fee
20 or fewer
$ 750
21 to 50
$ 1,000
51 to 100
$ 2,500
101 to 500
$ 5,000
501 to 1,000
$ 8,000
1,001 to 5,000
$15,000
5,001 to 10,000
$20,000
Over 10,000
$25,000
Audit Closing Agreement
Program—Audit Cap
• Applies to errors discovered during audit.
• Sanction is negotiated percentage of
Maximum Payment Amount (MPA).
• MPA is a monetary amount equal to the
tax IRS could collect upon disqualification.
• Sum of the following for all open tax years:
Maximum Payment Amount
• Tax on the trust (Form 1041)
• Additional employer income tax resulting
from the loss of plan contribution
deductions
• Additional participant income tax resulting
from early taxability of plan accounts, even
if not distributed or rolled over.
• Any other tax or penalties.
#1.
Failure to Timely Adopt Interim
Amendments
Examples
of Interim Amendments
• EGTRRA
• Minimum required distributions
• Final regulations for 401(k), 401(m) and
415
• Mandatory cashout
What You Need to Do
• Adopt all missing amendments
• Make VCP filing--$375 filing fee covers all
missing amendments
• Adopt prototype plan
• Track IRS amendment requirements
• Retirement News for Employers
#2.
Failure to Follow the Plan’s Definition
of Compensation for Determining
Contributions
#3
Failure to Include Eligible Employees
in the Plan or the Failure to Exclude
Ineligible Employees from the Plan
Characteristics of this Error
• Compensation to participant for lost
deferral opportunity
• Windfall to participants
– 50% instead of 100%
– 40% for after tax contributions
• Based on actual election or ADP
• Plus full matching contribution
• Adjusted for investment earnings or losses
Amy’s elective deferral election at the start of
2008 somehow was never processed by the
employer’s payroll system. As a result, Amy
received taxable compensation that should
have been contributed to the plan during the
first six months of the year. The plan’s ADP
for NHCEs was 5%. Amy’s elected to defer
10% of pay. Amy earned $20,000 for the six
months that no deferrals were made.
Amy’s missed deferral amount is $2,000
(i.e., 10% (Amy’s election percentage)
multiplied by $20,000 (her compensation
earned during the period in which her
employer failed to implement her election)).
The amount of the corrective contribution
the employer must make on Amy’s behalf is
$1,000 (i.e., 50% multiplied by Amy’s
$2,000 missed deferral amount).
Bob elected to defer 5% of his
compensation in 2008. The plan includes
bonuses in the definition of compensation
that is used for an employee making
elective contributions. Although Bob was
able to make deferrals on his base
compensation, the payroll system
overlooked his bonus. The ADP was 3%,
and Bob’s base compensation was
$19,000, and his bonus was $2,000.
Bob’s missed deferral amount is $100 (i.e.,
5% (Bob’s election percentage) multiplied
by $2,000 (his 2008 bonus from which
elective contributions were not made even
though he elected to make a contribution of
5% of all compensation, which included
bonuses)). The corrective contribution
required on behalf of Bob is $50 (i.e., 50%
multiplied by his $100 missed deferral).
A NHCE has compensation of $40,000 and
is incorrectly excluded for a full year from a
plan that provides a match equal to 100
percent of the first 3 percent of
compensation. The plan has a NHCE ADP
equal to 5 percent. The QNEC for lost
opportunity cost to make deferrals is
$1,000 ($40,000 x 5% x 50%). The QNEC
for the matching contribution is $1,200
($40,000 x 3%).
#4.
Failure to Satisfy Loan Provisions
Ways to Mess Up Plan Loans
• Loans that exceed maximum dollar
amount
• Loans with non-compliant payment
schedules
• Defaulted loans
On June 1, 2007, Jane took a $10,000 loan from her
employer’s 401(k) plan. The interest rate on the loan was
8%. Her loan was for a five-year period and required
monthly payments of $203. Her loan payment was to be
made by payroll withholding. The plan did not provide for
a “cure period” for missed installments. Paychecks are
issued at the beginning of the month. Jane’s loan
information was not forwarded to the payroll department
and, as a result, no payments were withheld in 2007. The
problem was discovered on December 15, 2007, during
an annual review of the plan’s records. July 1, 2007 is
considered to be the first missed payment, and her
outstanding loan balance of $10,067 (loan plus accrued
interest) is treated as a deemed distribution. Jane is
required to report $10,067 in income on her 2007 Form
1040.
#5.
Impermissible In-Service
Withdrawals
• George is the 100% owner of the George Company. The
company sponsors a 401(k) plan which provides that a
participant may take a distribution on account of hardship.
• Hardship withdrawals are available for the safe harbor
reasons.
• The plan requires that the participant use all other
sources of financing including proceeds from insurance,
liquidation of other assets, and loans from other
commercial sources before applying for a hardship
distribution.
• Jim, a plan participant, asked for and received a hardship
distribution of $20,000 from the plan. He did not provide a
reason for the distribution and did not establish that he
had used other sources of financing before applying for
the hardship distribution.
• The company should take reasonable steps
to ensure that Jim returns the erroneously
distributed amounts to the plan. Jim should
also be advised that to the extent any
amounts are not returned, they are not
eligible for tax favored treatment (i.e., the
amounts are not eligible for rollover to an
IRA or other retirement plan). In addition,
the plan’s administrative procedures should
be revised to ensure that the error does not
occur again.
#6.
Failure to Satisfy IRC 401(a)(9)
Minimum Distribution Rules
#7.
Employer Eligibility Failure
#8.
Failure to Pass the ADP/ACP
Nondiscrimination Tests under IRC
401(k) and 401(m)
How Can This Error Happen?
• Incorrectly classifying employees as HCE
or NHCE
• Using an incorrect definition of
compensation in the tests
• Calculating the test incorrectly
• Just not getting it done
• A calendar year plan with a 401(k)
arrangement fails the ADP test for the plan
year ending 12/31/07. The statutory
correction period is the 12-month period
from 01/01/08 to 12/31/08. The selfcorrection period under SCP runs from
01/01/09 to 12/31/10. After this date (unless
the violation is considered insignificant),
VCP must be used to correct the violation.
Correction Methods After Last Day of
Statutory Testing Year
• QNECs
• 1 to 1 correction method
• No-disaggregation
#9.
Failure to Properly Provide the
Minimum Top-Heavy Contribution
under IRC 416 to Non-Key
Employees
How Can This Error Happen?
• If the participant is a key employee at any time
during the previous plan year, the person is
considered a key employee for the entire year.
• If the key employee account balances exceed 60%,
the plan is TH.
• No 1,000 hour requirement for a TH allocation.
• TH minimum contribution is based on a total
compensation definition.
• Elective deferrals made by a non-key EE to a 401(k)
plan cannot be considered for the TH minimum
contribution.
#10.
Failure to Satisfy the Limits of IRC
415
• In 2007, John earned $100,000 in compensation as an employee of
the QP Corporation and was a participant in QP Corporation’s 401(k)
Plan. The plan permits elective contributions and provides a 100%
matching employer contribution for the first $8,000 in elective
contributions, as well as discretionary profit-sharing contributions. The
plan does not allow an employee to designate any portion of his or
her elective contribution as a Roth contribution. QP did not allocate
any forfeitures to participants in 2007. During 2007, QP made
contributions totaling $58,000 for John consisting of:
– elective contributions: $15,000
– employer matching contributions: $8,000
– employer profit-sharing contributions: $35,000
• The 2007 contribution limit for John is $45,000 (the lesser of $45,000
or 100% of John’s $100,000 compensation). Accordingly, the $58,000
contributions made for John in 2007 exceeded the limitation under
§415(c) by $13,000.
• QP discovered the failure to limit the contributions for John in early
2009.
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The correction of the excess contribution of $13,000 for John would be as
follows:
Step 1: John made $7,000 in unmatched elective contributions (elective
contributions of $15,000 less $8,000 that QP matched). The plan must
distribute the $7,000 (adjusted for earnings) to John. After the distribution,
there is still an excess contribution of $6,000 that the plan must correct, to the
extent possible, under Step 2.
Step 2: John made $8,000 in matched elective contributions. The plan must
distribute $3,000 in matched elective contributions (adjusted for earnings)
and forfeit the corresponding matching contribution of $3,000 (adjusted for
earnings). This step fully corrects John’s remaining $6,000 excess.
As a result, John will receive a total distribution of $10,000 (adjusted for
earnings). John must include the entire corrective distribution in his income.
However, John will not have to pay the additional 10% tax on early
distributions under §72(t) of the Code. The distribution is not eligible for
rollover to another qualified plan or an IRA. In addition, the plan will forfeit
$3,000 (adjusted for earnings) from John’s matching contribution account.
This amount will be transferred to an unallocated account and used to reduce
employer contributions required for the current year and if applicable,
subsequent year(s).
Bonus
Failure to Provide a Safe Harbor
401(k) Plan Notice
• Rainbow Company established a safe harbor 401(k) plan
in 2005. The plan provides for matching contributions in
an amount equal to: 100% of elective contributions up to
3% of the employee’s compensation plus 50% of elective
contributions greater than 3%, but not more than 5% of
the employee’s compensation. Eligible employees
received timely notices in 2004, 2005, and 2006.
However, in 2007 Rainbow failed to provide safe harbor
notice to its employees. In addition, Rainbow did not
furnish notices to employees who became eligible to
participate in the plan in 2008. Rainbow discovered the
problem when it conducted an internal review of its plan
operations at the end of 2008.
• Violet first became eligible to participate in
the plan on January 1, 2008. She did not
receive notice and Rainbow did not inform
her of her right to make elective
contributions to the plan. She earned
$20,000 in compensation in 2008.
• Indigo has been a participant in the plan since
2005. She has made elective contributions of 2%
of compensation each year, after receiving
notices in 2004, 2005, and 2006. While she did
not receive a notice in 2007, the human resource
department (HR) informed her that the
employer’s matching contribution formula will
remain the same for 2008 and that she should
inform HR if she wanted to make any changes to
her elective contributions for 2008.
• Exclusion of an eligible employee.
• Violet belongs in this category.
• Due to its failure to provide notice, Rainbow did
not inform Violet of her ability to make an elective
contribution when she was eligible. To correct the
failure, Rainbow must make a corrective
contribution for Violet to replace her missed
deferral opportunity and the missed matching
contributions that occurred because Rainbow
improperly excluded her from the plan.
• Fixing an administrative problem.
• Indigo belongs in this category.
• The failure to provide notice did not prevent
her from making an informed timely
election to change (or maintain) her
elective contribution to the plan. No
corrective contribution for Indigo is
required. The plan needs to reform its
procedures to ensure that she receives
timely notices in the future.
May 29, 2009
James R. Griffin
Jackson Walker L.L.P.
901 Main Street, Suite 6000
Dallas, Texas 75202
jgriffin@jw.com •
214.953.5827
TOP 10 401(K) ERRORS AND
HOW THE IRS WANTS YOU
TO FIX THEM