Because of the complexity involved in the operation of a retirement plan, mistakes are almost impossible to avoid. It is important to have measures in place to find mistakes, and to know how to make the necessary corrections when the mistakes are found. One error that can arise during the life of a 401(k) retirement plan is for an employee to be improperly excluded from making elective deferrals for a period of time. If you are an employer that has found this mistake, what are the necessary questions to ask and steps to take to get your plan back in compliance? The best way to provide these answers is through the use examples. This blog post will be the first of several in a series where we go through several examples.
Assume that ABC Company hires Karl late in 2017, and Karl should have been eligible for the 401(k) plan on January 1, 2018. ABC Company’s plan provides for a matching contribution of 100% up to the first 4% of compensation. Karl was mistakenly excluded from being able to make an elective deferral to the plan until the first pay period in May. The plan operates on a calendar plan year, is subject to ADP testing, and the ADP for Karl’s employee group for 2018 was 3%. Karl’s 2018 compensation was $100,000, and he decided not to contribute any of his income to his 401(k) in the months of May through December.
The first question the employer needs to answer is how long has Karl been improperly excluded from making elective deferrals to the 401(k) plan. The employer will be responsible for making a contribution on behalf of the employee for any error that prevents an employee from making elective deferrals for 3 months or longer. Contrastingly, if an employer finds that an employee has been improperly excluded from making elective deferrals and can correct the mistake so that the employee can make an elective deferral within the 3 month window, the employer is not obligated to make a contribution. In this example, Karl has been excluded from making an elective deferral for 4 months. The employer rightfully corrected the mistake by allowing Karl to contribute to the 401(k) plan in May through December, but the employer must also make a contribution to Karl’s account to fix the error from January to April.
Now that Karl’s employer needs to correct the failure, how much will the contribution be? That depends on how soon the error was discovered and corrected and whether the plan provides for automatic enrollment. The general rule is that ABC Company can correct this missed opportunity by making a contribution equal to 50% of the employee’s missed deferral. The employee’s missed deferral is equal to the employee’s compensation during the excluded period multiplied by a percentage that is dependent on the type of plan involved. For a plan that is subject to ADP testing, the applicable percentage is equal to the ADP of the employee’s group for the affected plan year. For a safe harbor 401(k) plan, the applicable percentage is 3%, or higher percentage up to the amount that an employee’s elective deferral would be matched by the plan 100%. This correction contribution is then adjusted to reflect the earnings that would have accumulated over the excluded period. The 50% may be reduced to 25% or 0% if one of the IRS exceptions apply (which we will address in a later blog post).
Karl also missed out on the match that would have been available to him had he made an elective deferral during the time period of exclusion. The corrective contribution for the failure to make a matching contribution is equal to the applicable match that the employer would have made had the employee made an elective deferral equal to the missed deferral amount, and the missed match is adjusted for earnings.
In Karl’s case, the missed deferral is equal to Karl’s compensation during the excluded period of January through April multiplied by the ADP for the Karl’s group for 2018 ($100,000 * 4/12 * .03= $750). ABC Company must contribute 50% of the missed deferral ($375) for Karl’s missed deferral opportunity. The missed match contribution is equal to the Karl’s missed deferral up to 3% of his salary during the period of exclusion, resulting in a $750 contribution to Karl. Finally, ABC must adjust the contributions for earnings.