The Internal Revenue Service ("IRS") recently updated its informal guidance about 401(k) plan errors. The updated materials contain simple guidance that is helpful for both identifying and correcting mistakes and avoiding future errors. The guidance, particularly the "401(k) Plan Fix-It Guide," is a useful starting point for employers interested in performing compliance audits of their 401(k) plans.
Identifying and Correcting Errors
The "401(k) Plan Fix-It Guide" provides a good checklist of common errors and summarizes the correction process with respect to each error. The most common errors include failure to:
- Amend a plan to reflect changes in the law
- Calculate contributions using the plan's definition of compensation
- Give eligible employees the opportunity to make elective deferrals
- Make hardship distributions in accordance with plan document requirements
- Limit elective deferrals to the maximum under the Internal Revenue Code ("Code") ($17,500 in 2014)
- Administer participant loans as required by the plan document and the Code
- Make required top-heavy minimum contributions
- Made matching contributions to all eligible employees
- Timely deposit elective deferrals
Many 401(k) plan errors may be corrected using one of two voluntary correction programs, the Self-Correction Program ("SCP") (which is generally only for operational failures) and the Voluntary Correction Program ("VCP"). Voluntary, employer-initiated correction likely will be far less costly than IRS-initiated correction under the Audit Closing Agreement Program ("Audit CAP") following the discovery of an error during a routine IRS audit or an IRS review in connection with a determination letter application. For example, correction of a failure to make required matching contributions under SCP simply requires making a corrective contribution to each affected participant equal to the missed matching contribution plus earnings. Correction under VCP requires making the same corrective contribution and paying an application fee of between $750 and $10,000 (based upon the number of participants). Under Audit CAP, the employer must make the same corrective contribution and then negotiate with the IRS to determine a sanction based on the "maximum payment amount," which is the sum of the taxes due from the plan trust, employer and participants for all open tax years if the plan were to be disqualified. (The sanction amount will always be greater than the VCP fee.)
Other guidance available on the IRS website includes "A Guide to Common Qualified Plan Requirements," which lists errors common to retirement plans generally, "Fixing Common Plan Mistakes," which contains links to explanations of the approved correction methods for a number of common errors that are generally more detailed and technical than the explanations in the 401(k) Plan Fix-It Guide, and "Correcting Plan Errors," which contains links to general information about the correction process, including links to VCP application forms.
Obviously, the IRS would prefer that employers avoid errors in the first place. The best way to prevent errors is to adopt written policies and procedures regarding plan administration and then perform audits to confirm that the policies and procedures are being followed. Additionally, employers must follow established policies and procedures to be eligible to correct errors under SCP.
The IRS website contains resources that are useful in developing plan policies and procedures. The "Policies, Procedures and Internal Controls Self-Audit" page contains a list of questions that employers may use to develop a plan's policies, procedures and internal controls, including:
- Who determines when an employee is eligible to participate in the plan?
- What is your plan's definition of compensation?
- How are matching and nonelective contribution amounts determined?
- How are requests for hardship distributions reviewed and approved?
- Who makes sure that the plan document is updated timely?
The "Internal Controls Protect Your Retirement Plan" page lists examples of good "internal control procedures," such as comparing salary deferral elections with the amounts deducted from wages, verifying that allocations and deferrals were determined using the correct definition of compensation and verifying that eligibility and vesting determinations were made using correct years of service totals. The materials are a good starting point for employers to create written policies and procedures for administering their 401(k) plans.
The volume of guidance on identifying, correcting and preventing 401(k) plan errors indicates that the IRS both recognizes that 401(k) plan errors are quite common and expects employers to take steps to identify errors and promptly correct them. Given the disparity between the penalties associated with voluntary correction under SCP or VCP and correction under Audit CAP, employers should seek to find and properly correct errors before the IRS discovers them.
King & Spalding recommends that employers take the following steps with respect to their 401(k) plans:
- Identify current plan documents, administrative policies and procedures and internal control procedures.
- Confirm that the administrative policies and procedures and internal control procedures have been updated to reflect plan amendments and current payroll practices.
- If there are no written administrative policies and procedures, promptly develop them along with internal control procedures to monitor compliance.
- Periodically perform a compliance audit to confirm that the plan is being administered in accordance with the plan document and administrative policies and procedures.