401(k) Find and Fix: Elective Deferral Mistake

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MISTAKE: Eligible employees weren’t given the opportunity to make an elective deferral election (exclusion of eligible employees).
Find the Mistake Fix the Mistake Avoid the Mistake
Review the plan document sections on eligibility and participation. Check with plan administrators to determine when employees are entering the plan. Make a qualified nonelective contribution (“QNEC”) for the employee that compensates for the missed deferral opportunity. Review Task information on running a compliant plan.  Monitor census information and apply participation requirements.


Your 401(k) plan document should contain definitions of “employee” and “eligible employee,” and provide specific requirements for when employees must become plan participants eligible to make elective deferrals. Employers sometimes incorrectly assume that the plan doesn’t cover certain employees, such as part-time employees. Similarly, employees who elect not to make elective deferrals are often mistakenly treated as ineligible employees under the plan when other plan contributions (such as profit sharing or other employer nonelective contributions) are made and nondiscrimination tests are run. To reduce the risk of omitting eligible employees, you should first and foremost make sure that everyone involved in the process has a clear understanding of what the plan document provides in terms of eligibility to participate in the plan. In addition, it is crucial to ensure the accuracy of employee data, such as dates of birth, hire, and termination (if applicable); number of hours worked; compensation for the year; 401(k) election information and any other information necessary to properly administer the plan and help guard against inadvertent mistakes of omission of eligible employees, or improper coverage of ineligible ones.

Generally, under most plans, it makes sense to initially assume that each employee who receives a Form W-2 is an eligible employee permitted to make elective deferrals and/or receive any other employer contributions, unless the plan document clearly states that the employee is in an excluded class (for example, by virtue of being part-time, covered by a collective bargaining agreement, or not having met the age and service requirements). Using the plan definition of eligible employee with the plan’s age and service and any other participation requirements, carefully determine and document each employee’s eligibility. If you hire leased employees, contract labor, or have shared ownership of other enterprises, determining eligible employees can be complicated, so it is more important than ever to make sure the plan’s provisions are clearly understood and followed to the letter.

A retirement plan doesn’t qualify for tax-preferential treatment unless it meets certain eligibility and participation requirements under the Internal Revenue Code and ERISA. These general rules are summarized below:

Once any applicable waiting period has expired and all eligibility conditions have been met, the plan administrator must give eligible employees the opportunity to make a salary deferral election and should retain copies of who is notified of this opportunity and when.

How to find the mistake

How to fix the mistake

Corrective Action:
Generally, if you didn’t give an employee the opportunity to make elective deferrals to a 401(k) plan, you must make a “qualified nonelective contribution” (“QNEC”) to the plan for the employee. This method is referenced in the IRS “401(k) Plan Fix-It Guide” which appears on the IRS website, and would be employed as a correction method in conjunction with the EPCRS Self-Correction Program (SCP) or Voluntary Correction Program (VCP) (see discussion below).

A QNEC is an employer contribution that is intended to compensate a participant for the lost opportunity to make elective deferrals. The QNEC must be 100% vested and is subject to the same distribution restrictions as elective deferrals. Although forfeitures (amounts lost to former participants who terminate employment prior to becoming fully vested) can be used to fund employer matching and non-discretionary contributions, under Internal Revenue Code rules, they cannot be used for funding QNECs.

To determine the amount of the QNEC, you must first determine whether the employee is a highly compensated employee (HCE) or a non-highly compensated employee (NHCE). The amount of the QNEC is equal to 50% of the employee’s missed deferral, which is determined by multiplying the affected employee’s compensation (as defined in the plan) for the year by the actual deferral percentage (ADP) for the employee’s group in the plan (either the group consisting of all HCEs in the plan, or the group consisting of all NHCEs in the plan) for the year of exclusion. The employee’s missed deferral amount may then need to be reduced to the extent necessary to ensure that the missed deferral does not exceed applicable plan limits.

Employer D sponsors a 401(k) plan with eight participants. The plan uses a calendar plan year. The plan has a one-year-of-service-eligibility requirement and provides for January 1 and July 1 entry dates. Jack, whom Employer D should have allowed the opportunity to make elective deferrals on January 1, 2020, wasn’t given that opportunity until January 1, 2021. Jack was a NHCE with compensation for 2020 of $80,000. The plan’s ADP for 2020 was 10% for the HCE group and 8% for the NHCE group. Employer D found this mistake in January 2023.

Employer D must make a corrective contribution in the form of a QNEC for the 2020 missed deferral opportunity. Jack’s missed deferral is equal to (i) the 8% ADP for the NHCEs group, multiplied by (ii) $80,000 (compensation earned for the year in which Employer D erroneously excluded Jack, 2020). The missed deferral amount based on this calculation is $6,400 ($80,000 x 8%). The missed deferral opportunity (corrective contribution, or QNEC) is $3,200 (50% multiplied by the missed deferral amount of $6,400). The QNEC in the amount of $3,200, must be adjusted for earnings through the date of deposit into Jack’s 401(k) plan account.

Correction programs available:
The IRS Employee Plans Compliance Resolution System (EPCRS) includes three separate programs, briefly described below, which may apply in this situation:

Self-Correction Program (SCP):
The example shows an operational failure (the EPCRS term for mistake) because Employer D failed to follow the plan terms by not giving Jack the opportunity to participate in the plan by making elective deferrals for the 2020 plan year. If the other eligibility requirements of SCP are satisfied (for example, the plan has established compliance practices and procedures in place), Employer D may use SCP to correct the failure.

Voluntary Correction Program (VCP):

An employer can generally use VCP to fix failures that cannot be corrected under SCP; for example, because the employer failed to maintain reasonable compliance procedures, because the failures were not timely corrected under SVP standards, or because the failures are considered to be egregious (which may result in a higher fee). The correction method may be the same as described previously or another correction method permitted under the EPCRS guidance. Employer D makes a VCP submission according to Revenue Procedure 2021-30. The fees for the VCP can be found on the IRS website. When making the submission, Employer D must file electronically using the www.pay.gov website, must include Forms 8950 and 8951, and should consider using the Model VCP Compliance Statement as provided in Revenue Procedure 2021-30, and supply any related supporting documents.

Audit Closing Agreement Program (CAP):
Audit CAP is the only EPCRS correction program available after the IRS discovers the failure during plan audit or otherwise. Under Audit CAP, the correction method may be the same as under SCP or VCP, but this will be subject to negotiations with the IRS. Employer D and the IRS enter into a closing agreement outlining the corrective action and negotiate a sanction based on the maximum payment amount — which will be greater than the VCP user fee would have been. Since the plan sponsor is responsible for the correct administration of the plan, expenses such as fees and sanctions under Audit CAP are generally not payable out of plan assets. (See “Plan Assets” for details.) Further, as previously stated, after the IRS finds the mistake on plan audit or otherwise, Audit CAP is the only correction method available, so it is important to self-identify and correct errors using SCP or VCP as soon as possible!

How to avoid the mistake