401(k) plans offer significant tax benefits to both employers and participants. Employers can deduct plan contributions and expenses, while participants can defer the taxation of their contributions and earnings until they withdraw their account. To offer these benefits, a 401(k) must satisfy certain plan qualification requirements under ERISA. These requirements are enforced by the IRS.
Severe consequences can result when a 401(k) plan fails to meet one or more of the plan qualification requirements – including IRS penalties for the employer or plan disqualification. When a 401(k) plan is disqualified, it’s tax benefits are revoked – potentially retroactively. That can mean additional taxes, amended tax returns and penalties for underreporting income for both the plan sponsor and participants. Yikes!
In truth, plan disqualifications are rare. Instead, most 401(k) plan qualification failures are corrected under one of the three programs that comprise the IRS’ Employee Plans Compliance Resolution System (EPCRS). One of these programs, the Voluntary Correction Program (VCP), allows employers to voluntarily correct failures that are too significant for self-correction with IRS approval.
To help employers avoid common qualification failures altogether, IRS published the Top Ten Failures Found in Voluntary Correction Program. If you sponsor a 401(k) plan, I recommend reviewing your plan for these issues. If you need help, ask your 401(k) provider. They should be able to guide your review – making it easy.
The Top 10 Failures
According to the IRS, the top 10 plan qualification failures found in the VCP include:
- Failure to amend the plan for tax law changes by the end of the period required by the law.
This results in a plan failing to operate in accordance with the current law because the plan document has not been amended to affect such change.
- Failure to follow the plan’s definition of compensation for determining contributions.
Usually, certain types of compensation are excluded, such as bonuses, commissions, or overtime, or certain types of compensation are included where they should have been excluded. This failure can result in participants receiving allocations to their accounts that are either greater than or less than the amount they should have received.
- Failure to include eligible employees in the plan or the failure to exclude ineligible employees from the plan.
This often occurs in a controlled group situation after a merger or acquisition. Where otherwise eligible employees are excluded, the excluded employees don’t receive an allocation of contributions to which they are entitled. Where ineligible employees are included in the plan, the employer has made additional contributions which it did not need to make to the plan.
Loan failures often result from the plan sponsor’s failure to withhold loan payments. Where a plan fails to collect loan repayments from participants, the loan is considered defaulted and the participant should be taxed on the loan in the year of default.
These requests relate to both defined benefit and contribution plans. The law provides that distributions to participants can be made upon certain events or the attainment of a specific age. This failure involves the circumstance where a distribution is made to a participant where the law or plan terms do not permit a distribution.
- Failure to satisfy IRC 401(a)(9) minimum distribution rules.
The law requires that a participant receive a distribution when they attain a certain age. This failure involves the plan not making distributions to participants where they have attained the age for required distributions under the law. The law requires that the participant pay an excise tax of 50% on the amount of required distribution if it is not made timely. The Service will, in appropriate cases, waive the excise tax if the plan sponsor requests the waiver in appropriate situations.
- Employer eligibility failure.
This occurs when an employer adopts a plan that it legally is not permitted to adopt. Common situations are where a government adopts a 401(k) plan or a tax-exempt entity (other than a 501(c)(3) entity or a public educational organization) adopts a 403(b) plan.
This failure could result from the employer not using the correct compensation or where the employer excluded eligible employees who elected not to participate in the 401(k) plan.
- Failure to properly provide the minimum top-heavy benefit or contribution under IRC 416 to non-key employees.
The law requires that if the account balances or accrued benefits of key employees (typically, owners) comprises a substantial portion of the assets of the plan (generally, 60% of plan assets), non-key employees are entitled to receive a minimum benefit or contribution.
- Failure to satisfy the limits of IRC 415.
The law limits the amount of contributions a participant can receive in a defined contribution plan (i.e., a 401(k) or profit-sharing plan) and the amount of benefits a participant can accrue in a defined benefit plan. This failure occurs where the employer or its third party administrator does not monitor the amount of contributions allocated or the amount of benefits accrued by participants.
Staying out of trouble is not difficult
In general, 401(k) plan qualification failures are caused by an employer failing to do three things: keeping their written plan document up to date for applicable law, operating their plan according to the terms of its document, or correcting any year-end testing failures. You can easily avoid these issues by doing just two things: understanding the terms of your plan document and hiring a service-oriented 401(k) provider. Such a provider will not only timely prepare any required amendments or year-end testing, they’ll pester you until you execute (sign and date) the amendments or approve any test corrections – keeping your plan out of trouble.