401(k) Find and Fix: Operations Mistakes


Geek Out!

 

MISTAKE: You didn’t base the plan operations on the terms of the plan document.
Find the Mistake Fix the Mistake Avoid the Mistake
Conduct an independent review of the plan document provisions as compared with its operation. Apply a reasonable correction method that would place the affected participants in the position they would have been in if there had been no operational plan defects. Review Task information on administering a compliant plan.  Ensure that the person(s) in charge of daily administration of the plan is properly trained to understand the plan document and to timely communicate any changes to all involved parties.

 

The plan sponsor/employer is ultimately responsible for keeping the plan in compliance with all relevant tax, labor and other applicable laws, regulations and other official guidance; however, there may be many administrative employees, vendors, and tax or legal professionals involved in servicing your plan. Therefore, it is critical that the plan sponsor ensures that each of these entities is servicing the plan in compliance with all legal requirements, as well as in accordance with the express terms of the plan document, at all times.

Plan sponsors should convey any amendments made to the plan document or changes to the plan’s operation to everyone who provides services to the plan. For example, if the plan document is amended to change the definition of compensation, then the plan sponsor should communicate that change to everyone involved in determining elective deferral amounts withheld from employee pay, performing the plan’s nondiscrimination tests, or allocating any employer contributions. Also, if the plan starts using a different definition of compensation in operation, make sure that the plan document reflects the proper definition or else is timely amended to reflect that change. Below are some common changes made to 401(k) plans requiring due diligence to identify any potential operational mistakes:

How to find the mistake

Plan administrators must be thoroughly familiar with their plan document to be able to determine if it has been consistently operated in accordance with all of its terms. Following the plan document in all respects is crucial for maintaining the plan’s tax-favored treatment for preventing a possible breach of fiduciary duty under ERISA. Plan administrators should periodically (at least annually) conduct an independent review of the plan and its operation. If plan administrative personnel or other service providers use a plan summary, checklist, spreadsheet, or similar tool, make sure that this resource accurately corresponds to the plan document in all respects. The 401(k) plan check-up and 401(k) plan checklist are valuable tools that can assist plan administrators and service providers in this regard.

How to fix the mistake

Corrective action:
Any errors discovered involving the operation of a 401(k) plan, should be corrected as soon as possible. Corrective action will generally involve using the IRS Employee Plans Compliance Resolution System (EPCRS – more details below).

Example:
Employer A’s 401(k) plan has 50 participants and provides for employer matching contributions of 50% of the elective deferrals made to the plan, up to the first 6% of compensation. The plan provides that these employer- matching contributions vest at the rate of 20% per year. A participant must work at least 1,000 hours in a plan year (which is based on a calendar year) to receive vesting credit for that year. Bob participated in the plan from January 1, 2019, to September 30, 2022, when he terminated employment. Bob worked 2,000 hours in each of the plan years ending on December 31 2019, December 31, 2020, and December 31, 2021. During the plan year ending on December 31, 2022, the year of his termination, Bob worked only 1,100 hours. At termination, Employer A paid Bob his plan benefits in a lump sum. At that time, Bob’s account balance attributable to employer matching contributions was $5,000. Employer A calculated Bob’s vested percentage of such account balance as 60%, i.e., 20% for each of the three full plan years in which he was employed. Accordingly, Bob was paid $3,000 from his employer matching contribution account.

A mistake has occurred because Employer A should have credited Bob with a vesting year of service for 2022, since, although he didn’t work 2.000 hours in his final plan year, he still worked in excess of 1,000 hours in that plan year. Bob should have been 80% vested for the four years of vesting service he actually completed, and the distribution he received in 2022 should have reflected this. Employer A discovered this mistake upon an internal plan audit completed on January 31, 2023.

Reasonable correction:
Employer A should use a reasonable correction method under EPCRS (see below) that places affected participants (in this case, Bob) in the same position he would have been in had the mistake not occurred. Revenue Procedure 2021-30, Section 6 (more about this Revenue Procedure, below) provides general correction principles that plans should use in determining an appropriate correction method. Generally speaking, if a plan corrects a failure (the EPCRS term for mistake) listed in Appendix A or Appendix B of Revenue Procedure 2021-30 according to the sample correction methods provided, the plan sponsor may be reasonably certain that the proposed correction method will be accepted by the IRS.

In this Example, Employer A must make a corrective distribution to Bob to correct the vesting failure. Employer A should credit Bob with an additional 20% of the employer matching contribution account balance of $5,000, i.e., an additional $1,000, plus any additional earnings from the date of the original distribution to the date of the corrective distribution.

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:
The example illustrates an operational failure, because Employer A didn’t follow the plan terms when it failed to properly vest Bob’s account. Assuming that all of the eligibility requirements of SCP are satisfied (for example, the employer has established practices and procedures in place designed to facilitate compliance), then Employer A should be able to use SCP to correct the mistake.

In this Example, since only one out of 50 participants was affected by the failure, it was “caught” early, and a relatively small amount of money is involved, it appears likely that, under the old rules, the failure would be deemed to be insignificant. Consequently, Employer A would need to make a corrective distribution to Bob in the amount of $1,000, plus earnings, but could most likely do so without regard to the former three-year correction period (measured from date of occurrence) for significant failures.

However, since the failure in the present example occurred prior to, but was not discovered until after, December 29, 2022, Employer A should use the post-SECURE 2.0 rules and correct the mistake within a “reasonable period” after the mistake has been identified (i.e., the corrective distribution must be made by no later than the last day of the 18th month following the date the failure was discovered — on or before July 31, 2024).

Voluntary Correction Program:
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 above under SCP. Employer A makes a VCP submission according to Revenue Procedure 2021-30. Assuming the plan has fewer than $500,000 in assets, the fee for the VCP submission would be $1,500. When making the submission, A must file electronically using the www.pay.gov website, must include Forms 8950 and 8951 and consider using the Model VCP Compliance Statement referred to in Revenue Procedure 2021-30 and any related supporting documents, as applicable.

Audit Closing Agreement Program:
Audit CAP is the only EPCRS correction program available after the IRS or DOL 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. To be eligible for Audit Cap, a plan must currently be “under investigation” (being audited) by either the DOL or the IRS. Employer A 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.) Once the IRS or DOL finds the mistake, 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

 

Reference Source: IRS 401(k) Plan Fix-It Guide