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 for the employee that compensates for the missed deferral opportunity. Review the ComplianceDashboard  information on running a compliant plan.  Monitor census information and apply participation requirements.


Your 401(k) plan document should contain a definition of “employee” and provide requirements for when employees must become plan participants eligible to make elective deferrals. Employers sometimes assume 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 are made and tests run. To reduce the risk of omitting eligible employees, you should ensure the accuracy of employee data such as dates of birth, hire, and termination; number of hours worked; compensation for the year; 401(k) election information and any other information necessary to properly administer the plan.

Generally, treat each employee who receives a Form W-2 as an eligible employee unless you can properly exclude that employee by the plan terms. Using the plan definition of eligible employee with the plan age and service requirements, determine each employee’s eligibility. If you use leased employees, contract labor, or have shared ownership of other enterprises, determining eligible employees can be complicated.

A retirement plan doesn’t qualify for tax-preferential treatment unless it meets the eligibility and participation standards. These general rules are:

In addition, you 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 to the plan for the employee. This contribution must compensate for the missed deferral opportunity. The corrective QNEC is an employer contribution that’s intended to replace the lost opportunity to a participant who wasn’t permitted to make elective deferrals. The QNEC must be 100% vested and subject to the same distribution restrictions as elective deferrals. Forfeitures can’t be used for 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 determined by multiplying the actual deferral percentage for the employee’s group (HCE or NHCE) in the plan for the year of exclusion by the employee’s compensation for that year.

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’ve allowed the opportunity to make elective deferrals on January 1, 2018, wasn’t given that opportunity until January 1, 2019. Jack was a NHCE with compensation for 2018 of $80,000. The ADP for 2018 was 10% for HCEs and 8% for NHCEs. Employer D found this mistake in 2019.

Employer D must make a corrective contribution for the 2018 missed deferral opportunity. Jack’s missed deferral is equal to the 8% ADP for NHCEs multiplied by $80,000 (compensation earned for the portion of the year in which Employer D erroneously excluded Jack, January 1 through December 31, 2018). The missed deferral amount based on this calculation is $6,400 ($80,000 x 8%). The missed deferral opportunity (corrective contribution) is $3,200 (50% multiplied by the missed deferral of $6,400). Employer D must make a corrective contribution of $3,200, adjusted for earnings through the date of deposit, for Jack.

Correction programs available:

Self-Correction Program (SCP):
The example shows an operational problem because Employer D failed to follow the plan terms by not giving Jack the opportunity to participate in the plan for the plan year. If the other eligibility requirements of SCP are satisfied, Employer D may use SCP to correct the failure.

Voluntary Correction Program:

Correction is the same as under “Corrective Action.” 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 a VCP submission, Employer D should include Forms 8950 and 8951 and often will include Forms 14568-A through 14568-I, “Schedules.” These must be submitted electronically in PDF format.

Audit Closing Agreement Program:
Under Audit CAP, correction is the same as under “Corrective Action.” Employer D and the IRS enter into a closing agreement outlining the corrective action and negotiate a sanction based on the maximum payment amount.

How to avoid the mistake: