Common Mistakes with Retirement Plan Management

Filed under: Benefits

Retirement plan sponsors are required to navigate a complex web of rules and regulations that govern employer benefits. Inevitably, this leads to errors. Mistakes can run the gamut from not updating the plan to reflect legislative changes to not complying with 401(k) nondiscrimination tests. The following are common errors associated with retirement plan management.

Contribution Errors

Eligibility – To retain qualified plan status under IRS rules and the Employee Retirement Income Security Act, a 401(k) plan must meet deferral and contribution percentage tests that compare plan participation rates among lower and higher compensated employees (HCEs). These rules mandate minimum vesting and allocation requirements in plans where the majority of assets are owned by higher-paid/key employees, to ensure that lower-paid workers receive at least a minimum benefit.

Compensation Calculation – While an employer’s annual matching or profit-sharing contributions are typically based on each worker’s compensation, careful attention must be paid to how the retirement plan defines compensation. In other words, a miscalculation may include ineligible bonuses or other supplementary income that is not allowed by the plan. If an employer fails to correct this imbalance, the plan can be disqualified.

Roth Option – In plans that offer a Roth IRA option, employers sometimes fail to separate the contribution and treat it as a pre-tax deferral. To fix this mistake, the employer must transfer those assets, adjusted for earnings, from the pre-tax account to the Roth account. The adjustment must be reported on a corrected W-2 form and the worker must file an amended Form 1040 for the year of the incorrect deferral. Alternatively, the employer may opt to include the pre-tax contribution as part of the worker’s income in the year it is deferred. For the latter option, the employer may elect to compensate the worker for the additional taxes owed due to the mistake (which also must be reported as taxable income).

Timeliness – Employers often make the following timing mistakes:

• Not depositing participant or employer contributions in a timely manner
• Not distributing employer-matching contributions according to the plan’s vesting schedule
• Not distributing excess contributions in the calendar year, which could result in additional taxes and penalties for both the participant and employer.

Distribution Errors

Participant Loans – Retirement plans that allow loans must meet both plan document and the following IRC Section 72(p) requirements:

• Participants may borrow up to 50% of their vested account balance, not to exceed $50,000, via a nontaxable loan
• Participants may borrow up to $10,000 in excess of half the account balance if the additional amount is secured by collateral
• The participant has up to five years to repay the loan with interest, which is also credited to the retirement account

Loans that do not meet these criteria may be treated as a taxable distribution to the participant. When non-compliance is due to employer error (e.g., failure to withhold payroll for repayment of the loan), the employer may be required to pay a portion of the repayment to correct the defaulted loan.

Hardship Withdrawals – Hardship withdrawals must follow plan rules such as be used to pay for medical or educational expenses, or to purchase a principal residence, or to avoid eviction or foreclosure. The withdrawal is limited to the amount necessary to meet the particular hardship. These distributions are subject to income taxes in the year withdrawn, as well as a 10 percent penalty if withdrawn before age 59½. Workers cannot repay the amount back to the plan.

Plan Administration

Fiduciary Duty – Plan sponsors should periodically conduct a competitive review of their benefits administrator to compare service levels and fair pricing. Even if the plan sponsor decides to retain the current provider, this exercise complies with their fiduciary duty.

Compliance – Plan sponsors are responsible for ensuring the retirement plan complies with all regulatory requirements. Noncompliance can lead to personal liability, tax penalties, or loss of the plan’s tax-deferred status. Remember that most 401(k) plans must file an annual return (Form 5500) with the IRS.

Problem-Solving Resources

Fortunately, the IRS has developed some resources to help employers fix retirement plan errors. The IRS Employer Plans Compliance Resolution System (EPCRS) offers three options:

• Self-Correction Program (SCP) – plan sponsor may self-correct mistakes without notifying the IRS or paying fees.
• Voluntary Correction Program (VCP) – plan sponsor may pay a fee and secure IRS approval to fix retirement plan errors at any time prior to an audit
• Audit Closing Agreement Program (Audit CAP) – plan sponsor may pay a fine and correct mistakes during a plan audit

For more information visit the EPCRS webpage.

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