401(k) Find and Fix: Elective Deferral Mistake

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:

• A plan may not require an employee to be older than 21 to participate, and
• Two ways to credit service to an employee:
  • Hours of service: A 401(k) plan may not require more than a year of service as a condition of being eligible to participate.
    • A year of service means a calendar year, plan year, or any other consecutive 12-month period during which the employee completes at least 1,000 hours of service, starting on the employment commencement date.
    • There are special rules for long-term, part-time employees who complete 500 hours of service or more during three consecutive years (for plan years beginning in and after 2025, this will decrease to two consecutive years).
  • Elapsed time: Under the elapsed time method, an employee’s eligibility to participate isn’t based on the completion of a specified number of hours of service, but it’s generally determined in reference to a 12-month period.
• An eligible employee must enter the plan within 6 months after satisfying the eligibility requirements under the plan.
• The plan document may be more liberal by allowing a younger age and lesser service requirement. For example, a plan may allow a person to participate immediately when hired.
• Your plan document contains the definitions and requirements for becoming a plan participant.

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

• Thoroughly review your plan document’s provisions concerning eligibility and participation.
• Make a list of all employees who received a W-2.
• Compare each employee’s date of hire, birth, termination (if applicable), and number of hours worked against the eligibility and participation requirements of the plan document.
• Determine the date that each employee is entitled to become a plan participant (plan entry date) according to the plan document.
• Based on the foregoing, determine the exact date that each eligible employee should enter the plan.
• Compare this date with the date that each employee actually entered the plan.
• Note and document any instances of employees who entered the plan improperly, or who should have entered the plan but were not given the opportunity to do so.

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.

Example:
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.

• No fees for self-correction, and no advance IRS approval required.
• Practices and procedures reasonably designed to facilitate compliance must be in place and must be followed.
• Prior to December 29, 2022, the EPCRS rules provide that if the mistakes are significant in the aggregate:
  • They must be corrected by the last day of the third plan year following the plan year in which the failure occurred. In our example, Employer D would need to complete correction by December 31, 2023.
  • If not corrected by December 31, 2023, under the old rules, Employer D isn’t eligible for SCP and must correct under VCP (see discussion, below).
• If the mistakes are insignificant in the aggregate, Employer D can correct beyond the three-year correction period for significant errors. Whether a mistake is insignificant depends on all facts and circumstances.
• Effective December 29, 2022, the SECURE 2.0 Act made substantial changes to the rules regarding SCP – notably, the former distinction between “significant” and “insignificant” mistakes has been eliminated.
• Prior to the enactment of SECURE 2.0, the rules regarding correction of 401(k) plan compliance mistakes were set out in a document known as Revenue Procedure 2021-30. SECURE 2.0 directs the IRS to issue an updated Revenue Procedure to replace Rev. Proc. 2021-30 within two years of the December 29, 2022 effective date. In the meantime, interim guidance in the form of IRS Notice 2023-43 provides that a plan sponsor is not prevented from self-correcting a mistake using the SECURE 2.0 rules on or after December 29, 2022 merely because the mistake occurred prior to December 29, 2022.
• Accordingly, since the failure in the present example occurred prior to, but was not discovered until, after December 29, 2022, Employer D should be able to correct the mistake within a “reasonable period” after the mistake has been identified. Notice 2023-43 provides that “reasonable period” means that failures of this type must be corrected by the last day of the 18th month following the date the mistake is discovered by the plan sponsor (not the date the mistake occurred).
• The failure must be due to an error or oversight and cannot be “egregious” (as defined in Rev. Proc. 2021-30); for example, the plan must not have consistently and improperly favored highly compensated employees or improperly benefited the owner or employer.
• The correction method could be identical to the method outlined above (as referenced in the “401(k) Plan Fix-It Guide”) or it could be another correction method authorized for use under the same circumstances in the EPCRS guidance (Revenue Procedure 2021-30).
• Because certain questions remain unanswered, pending issuance of the updated Revenue Procedure that fully incorporates the new SECURE 2.0 provisions, plan sponsors are strongly advised to consult with their legal counsel or other professional ERISA advisor prior to using SCP to correct mistakes.
• Employer D should fully and carefully document the steps taken to make the correction under SCP.

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

• Review information on running a compliant plan.
• Review your plan document for the definitions of “employee” and “eligible employee,” and those provisions governing employee eligibility.
• If the plan document is amended, check all the plan’s definitions and sections addressing eligibility against the former document, noting any differences. Have a centralized person or department responsible for maintaining all plan documents, including amendments.
• If you amend your plan document – particularly if you change the plan’s eligibility criteria in any way — communicate those changes to everyone involved in the plan’s operation. Plan sponsors should develop an internal communication mechanism to timely and accurately advise plan administrators and outside service providers (outside plan consultant, actuary and/or third-party administrator/record keeper) of changes.
• Provide proper training about the plan document to in-house personnel who determine employee eligibility.
• Look at your payroll records for the total number of employees, birth dates, hire dates, number of hours worked, and other pertinent information. Also inspect Form(s) W-2 and state unemployment tax returns and compare employee data on these records with the payroll records to see if employee counts and data are accurate.
• Know what your third-party administrators have agreed to provide. They may be relying on you for information, such as details as to all plan eligibility requirements, including any special conditions or exclusions. Retain a copy of your third-party administrator service contract including any updated contracts; and keep a summary of what’s being supplied to the plan by the third-party administrator, actuary or consultant. Keep this service contract and summary with the person responsible for maintaining all plan documents.
• Establish protocols and a corrective action plan that will be triggered when errors are identified.