Mistakes happen. It’s human nature. But they can be costly to an employer in terms of time and money when they involve a retirement plan, such as a 401(k) or 403(b). As a plan sponsor and administrator, you can save yourself trouble by understanding the common plan errors, how to prevent them, and how to correct them. Plan errors generally come in two forms: operational errors and plan document errors.
Operational errors
It sometimes happens that the plan sponsor does not understand the detailed provisions of the plan document and, as a result, the plan operations are not implemented correctly. If so, the plan sponsor should review and prospectively change policies and procedures to match the plan document. The sponsor is responsible for missed or improperly calculated contributions. The only way to prevent these types of errors is to thoroughly understand the provisions of the plan document. Plan documents are complex, so it makes sense to seek professional guidance to clarify or confirm your understanding of your plan document.
Plan document errors
Errors occasionally occur because the plan document does not properly reflect the intentions of the plan sponsor. These errors generally occur during plan amendments and complete document restatements (as with a change in service providers) when an improper box is checked (or not checked) on the adoption agreement, or a plan specification is ambiguous and could be interpreted in different ways. Overly complex plan specifications create confusion and administrative burden. The contribution cost you are trying to save by electing certain provisions can be lost if corrective contributions, fines, and penalties result. To correct these issues, the plan may need to be formally amended. The best way to avoid this type of error is to keep your plan document provisions simple.
Following are descriptions of the more frequent plan errors we encounter during plan audits. We note how they can be identified, corrected, or prevented by a plan sponsor.
Compensation
One of the most common plan errors occurs when compensation used to compute plan contributions and various tests does not match the definition stated in the plan document. For example, most plan documents define compensation as “W-2 wages.” This sounds simple enough, but many plan sponsors don’t realize this definition includes all taxable wages, including non-cash fringe benefits such as group-term life insurance premiums or taxable domestic partner health insurance benefits. In addition, unless otherwise specifically excluded in the plan document, this definition also includes bonuses, awards, and stipends that are considered taxable income and reported on Form W-2. In order to prevent this type of error, confirm that the definition of compensation in your plan document properly reflects the plan sponsor’s intentions and that payroll is properly set up to use the correct compensation when calculating employee salary deferrals or employer contributions (e.g., matching contributions).
If the amount of employee salary deferral contributions or employer contributions is too low due to use of an incorrect definition of compensation, in most cases the employer is responsible for making up the missed contributions by making additional employer contributions to the plan. If too much has been contributed, the excess amounts must be removed from a participant’s account. See further discussion below for additional information on excess contributions.
Contributions
The IRS sets annual contribution and compensation limits for employee benefit plans. Employee salary deferral contributions are limited to $17,000 for 2012 ($17,500 for 2013). Employees aged 50 or older can contribute an additional $5,500 as a catch-up contribution, but only if the plan document allows it. In addition, only the first $250,000 of compensation earned by an employee in 2012 ($255,000 for 2013) may be used to allocate any employer contributions. To prevent excess employee or employer contributions, a plan sponsor should monitor employee contributions throughout the year and perform annual compliance testing shortly after a plan’s year-end to verify adherence to these limits. Failure to identify these errors in a timely manner may require an employee to re-file his or her personal tax return.
If it is discovered that a participant contributed too much in employee salary deferral contributions, the excess amounts should be refunded or distributed to the participant. However, if the excess contributions (e.g., excess annual additions) are related to employer contributions, the plan documents must be reviewed to determine if employee salary deferral contributions must be distributed or if the excess amounts must be forfeited from the participant’s account and placed in a plan suspense account to be applied to future employer contributions. Importantly, excess employer contributions should not be returned directly to the employer, as this could potentially be construed as a prohibited transaction between the employer and the plan.
If it is discovered that a participant contributed too little (e.g., due to use of the wrong compensation or failure to follow an employee’s written deferral election), the plan sponsor should contribute a corrective contribution equal to 50% of the missed contributions, plus lost earnings. However, if the underfunding relates to employer contributions, the plan sponsor should contribute 100% of the missed contributions, plus lost earnings. There are various ways in which the lost earnings can be calculated.
Eligibility
Determining whether and when an employee becomes eligible to participate can also be a challenge and can create inadvertent errors. Many plans have age and length of service eligibility requirements and specific plan entry dates that must be followed. In addition, some plans elect to exclude certain classes of employees, such as per diem or part-time employees, from participating in the plan. While it is permissible to exclude certain classes of employees in a non-discriminatory manner, what should happen when an employee changes from an ineligible class to an eligible class or vice versa? This could mean an employee is eligible for part of a year and ineligible for part of a year. Regular monitoring of the service requirements and changes in status can help prevent errors from occurring. If errors are identified, additional contributions similar to those discussed under the Contributions section above may need to be made or excess contributions may need to be refunded to plan participants.
Distributions
Recent downturns in the economy have resulted in more frequent requests for hardship withdrawals or participant loans. Many plan sponsors will approve a hardship distribution or participant loan, not realizing the plan document does not allow them. Or, some plans allow hardship withdrawals to be taken only from accumulated employee salary deferral contributions, thus limiting the amount available to be distributed to the participant. Plans that do allow for hardship withdrawals often require employee salary deferral contributions to the plan to cease for a period of six to twelve months after a hardship withdrawal is taken. Plan sponsors must be sure to stop employee salary deferral contributions; otherwise, deferrals will be deemed to be excess contributions and have to be returned to the affected plan participant.
Most plans also require all other forms of distributions to be taken prior to hardship withdrawals. Unbeknownst to many plan sponsors, this includes participant loans from the plan. In addition, some plans allow more than one loan to be outstanding at a time. In such a case, employees will be required to take multiple loans before they can take a hardship withdrawal.
Speaking of plan loans, these have limits, too. In a 12-month period, plan loans generally cannot exceed the lesser of $50,000 or 50% of a participant’s vested account balance. The 12-month rule is particularly tricky and makes it impossible to, for example, pay off a $20,000 loan and borrow $40,000 the same day, because the sum of the two loans ($60,000) exceeds the 12-month $50,000 limit. As with hardship withdrawals, many plans permit participants to borrow only accumulated employee salary deferral contributions. Correcting errors relating to plan loans and distributions is difficult and sensitive since it often necessitates requesting money back from the participant. Unfortunately, participants who request hardship withdrawals or loans in the first place generally don’t have money available to pay back to the plan.
Timely deposit of employee contributions
The Department of Labor (DOL) requires a plan sponsor to deposit (“remit”) any contributions withheld from participant paychecks into the plan as soon as “reasonably practicable.” This vague term has been debated by the experts for years. Essentially, it means an employer should remit employee salary deferral contributions to the plan as soon as it can reasonably segregate these funds from its own general assets. This could be two days for one employer or five for another. Some employers even have the ability to prefund these contributions before the actual withholding occurs. There is no safe-harbor timeframe for large plans. Informal guidance seems to indicate that for large plans, employee contributions should be deposited within three to five business days, but again, the technical requirement is as soon as reasonably practicable. Regardless of what is reasonably practicable, in no event can this remittance be more 15 business days into the month following the month of withholding. Exceeding this maximum timeframe automatically results in a prohibited transaction between the plan sponsor and the plan and must be reported to the DOL. But don’t rely on that 15-day rule—a deposit that is not made as soon as reasonably practicable, even though complying with the 15-day rule, can be considered a prohibited transaction. If there are late deposits, a plan sponsor is generally required to contribute lost earnings to participants’ accounts for the late deposits.
Correction period
Once a mistake is identified, it’s important to determine how many years back it extends and how many employees are affected. Only then can a plan sponsor determine the impact on the affected participants—were they overfunded or underfunded? This can require detailed recalculations of employee and employer contributions based on the plan document provisions in effect when the error occurred. In such cases, you may wish to engage the help of a plan professional to untangle the situation, determine what is right and wrong, ensure the issue is properly corrected, and help you make adjustments going forward.
Whatever the reason for your plan error, whether your documents or your administrative procedures are wrong, or your procedures just weren’t followed, BerryDunn has experts and professionals who can provide valuable guidance and perform detailed plan reviews to ensure full compliance and understanding. Contact us today with questions you may have on your plan.
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