Three Common 401(k) Plan Errors (As Told By Employee Benefit Plan Auditors)
We are well aware of the multitude of errors that can occur in the administration of 401(k) plans. Plan administrators may need to correct errors or instances of noncompliance in order for plans to maintain their tax qualified status. Correcting these common errors and noncompliance issues can be both time-consuming and costly. As such, we recommend plan administrators consider the potential issues to prevent these errors.
Incorrect Definition of Eligible Compensation
One of the most common plan errors that we see is the failure to use the correct definition of compensation to calculate participant deferrals and employer contributions. There are many different types of compensation that can be included or excluded from the definition of eligible compensation, such as bonuses, overtime pay, commissions, auto and other allowances, and fringe benefits, among others. Additionally, some plans use different definitions of compensation for employee deferrals, employer match, and even profit-sharing contributions, further complicating the calculations and plan administration.
What is the correct compensation? Each plan’s definition of compensation should be clearly defined in the plan document. Yet this is still a common mistake. Why? It may often be as simple as plan management not reading the definition of compensation carefully—or sometimes not reading it at all. In other cases, the plan document is not reviewed when new payroll codes are implemented, and eligible compensation that was initially set up correctly is no longer calculated in accordance with the plan document. Correcting this error can be quite burdensome for plan sponsors. The sponsor may have to go back multiple years to recalculate the correct definition of compensation for all employees and contribute additional amounts to the plan in order to make the plan participant accounts whole for any missed contributions and lost earnings. Plan administrators also need to consider the treatment for participants who have left the plan and may be due contributions as a result of this error. We always recommend consulting with the plan’s ERISA attorney to determine the best correction method.
To avoid this potentially time-consuming and costly error, plan administrators and management must clearly understand the definition of eligible compensation, not only when the plan is created, but on an ongoing basis. It is crucial to review the plan document, particularly when there is a change in personnel or payroll provider, or when new types of compensation are added to the payroll system.
Late Participant Deferrals
Another common error is late participant deferrals. Employee contributions that are withheld from participants’ pay must generally be remitted to the plan on the earliest date that those contributions can be reasonably segregated from the employer’s general assets. It cannot be later than the 15th business day of the month following the month the participant contributions were withheld. This general rule often confuses plan sponsors in a number of ways. First and foremost, the 15th day provision is not a safe harbor. Thus, if contributions are not remitted to the plan within a “reasonable” timeframe, they would be considered late remittances, even if they were remitted within the 15th business day of the next month. To comply with this, plan sponsors must know the earliest date they can reasonably segregate the contributions.
What is a reasonable timeframe? Most employers routinely submit payroll taxes withheld from employee paychecks as soon as one to two business days, or even the same day, as the date of payroll. The U.S. Department of Labor (DOL) often takes the position that if the payroll taxes can be remitted in that timeframe, so should retirement plan contributions. Late remittances are considered prohibited transactions that must be corrected and reported on both the Form 5500 and the plan’s financial statements. To correct this error, the plan sponsor must calculate and fund lost investment earnings on the late remittances in order to make the participant’s accounts whole. This can take considerable time to calculate, but often results in a very small monetary amount. While the amounts of lost earnings are typically small, there is no material or minimum amount whereby a correction would not be appropriate.
Plan sponsors should determine when contributions can be reasonably segregated, and this conclusion should be documented and monitored to make sure remittances are timely and that any late remittances are reported and appropriately corrected.
Hardship Distributions Not Administered Properly
Many plans allow for hardship distributions, whereby participants can receive distributions because of immediate and heavy financial needs. Hardship distributions must be limited to cover that need, and the employee must not be able to reasonably obtain the funds from another source. The plan document will define what is considered an immediate and heavy financial need, as well as any other requirements related to hardship withdrawals, such as requiring participants to obtain a loan from the plan prior to receiving a hardship distribution.
What’s the problem? We have seen where hardship distributions were paid to participants who did not qualify, either because there was not a documented financial need or because the participant did not first take out a plan loan. In addition, many plans have provisions where a participant cannot make contributions for a certain period of time after receiving a hardship distribution, typically for six months. Administering this provision can be challenging (and easily be overlooked) if the plan administrator is not completely familiar with the plan document.
These operational errors need to be corrected, and the plan may need to recover the erroneously distributed amounts from the participant. In order to prevent these errors, plan sponsors and third-party administrators should have a formal approval process for hardship distributions, including obtaining documentation of the hardship reason, certification of the unavailability of alternative funding sources, and a procedure to assure employee contributions cease, if applicable. Again, consultation with an ERISA attorney is always advised in order to determine the best correction method.
While this list is not all inclusive, these are the errors we most commonly see in our 401(k) plan audit engagements. Other common noncompliance areas are failure to: (1) follow the provisions surrounding loan defaults; (2) increase deferral percentages annually when there is an escalation provision in the auto enrollment feature; and (3) include part-time employees in the plan when the plan document does not exclude them. There are, of course, many others.
We find the best protection is to implement a strong internal control system around plan operations, along with a set of plan-specific procedural checklists (contribution calculators, contribution deposit calendars and hardship withdrawal approvals).
Also, all parties responsible for administering should regularly review the plan document.
This article originally appeared in Issue No. 17 of Confero.