Pension Trends Newsletter
March, 2011 Adobe Acrobat Version | Author Profile | Pension Trends ArchiveThe Top 10 401(k) Plan Audit Failures
A Top 10 List You Won’t See on Letterman
At the February meeting of the Portland Chapter of the Western Pension and Benefits Conference, Shannon Takizawa from the Portland office of the Internal Revenue Service shared with us the top 10 plan administration failures that surface when the IRS conducts an audit of a 401(k) plan. In addition to listing each failure, we have added our insights and some suggestions for avoiding these common failures. We hope you find the information helpful.
The ten most commonly cited 401(k) plan audit failures are:
1. Plan document failures such as unsigned plan documents or plan amendments and missing minutes confirming adoption of the plan or amendment. If a plan amendment is not adopted, it does not take effect, even if it is sitting in the file and everyone thought it has been adopted. Ms. Takizawa indicated that they will consider most any kind of written evidence that an action was taken by a plan sponsor to adopt the plan amendment or even the initial adoption of a new plan.
Suggestion: Make it the responsibility of someone other than the plan sponsor, such as the plan’s third party administer or the plan sponsor’s legal counsel, to annually ask the plan sponsor for copies of any new plan documents received during the year. Another possibility would be to annually take written action to adopt all amendments and other changes to the 401(k) plan proposed by the prototype or volume submitter document provider.
2. Failure to timely deposit salary deferrals. It is a BIG no‐no for an employer to withhold employee salary deferral contributions and then not deposit them into the 401(k) plan right away. Both the IRS and the DOL are relentless in their sanctioning of employers who act otherwise, either intentionally or inadvertently. Among other sanctions, the plan sponsor will be required to make up for any investment gains employees would have earned had the deposits been made timely.
Suggestion: Most payroll services will automatically forward salary deferrals to the 401(k) plan concurrently with processing payroll and forwarding withholdings to the government. If a plan sponsor is doing its own payroll, do more than rely upon your payroll clerk to remember to send in the deferrals when processing payroll each pay period.
3. Failure to follow the terms of the plan. Each of the remaining seven items falls on the list under this general category, but they are listed separately because of their prevalence.
Suggestion: Administering a 401(k) plan is not a good do‐it‐yourself project. Hire a qualified third party administration (TPA) firm. They are familiar with the legal language in a plan document and the applicable IRS and DOL regulations governing administration of 401(k) plans. At a minimum, have your CPA or other advisor review your self‐administration of the plan. If you make one of the seven common mistakes we describe next, the cost dealing with of an IRS audit will be the least of your expenses.
4. Failure to use the correct plan definition of compensation. It is not unusual for a plan document to use one definition of compensation for one purpose and a different definition for another. Example: W‐2 compensation is used to allocate the profit sharing contribution to the plan, but “415” compensation is used for nondiscrimination testing. Not knowing any better, you do the nondiscrimination testing using W‐2 compensation. You thought the plan barely passed last year, but when you use the correct compensation, the plan fails the required nondiscrimination test. It can and does happen.
5. Failure to follow the plan’s matching contribution provisions. Typical causes for failure are inadvertent exclusion of eligible employees or using the wrong definition of compensation (see #3 above). Example: Not allocating matching contributions to employees who terminated employment before year end even though they worked 1000 hours and therefore qualified for the matching contribution under the terms of the plan. (The additional requirement of being employed on the last day of the plan year is common for profit sharing allocations; less so for a match.)
6. Failure to satisfy ADP/ACP testing requirements. ADP/ACP testing failures can result from many different causes. Perhaps the most common relates to #6 below: excluding employees from the testing that, if included, would have resulted in a failing test. Another common cause of failure is for a plan to proceed on the basis it qualifies as a safe harbor plan exempt from testing, but for some reason fails to qualify as a safe harbor plan.
7. Failure to include all eligible employees such as excluding part‐time employees without counting actual hours or excluding employees of eligible subsidiaries. For many purposes, 1000 hours of service in a year is the appropriate measure of eligibility, but for other purposes, a 500 hour standard applies. For still other purposes, you may exclude employees who worked 1000 hours if they are not employed on the last day of the plan year – but not always. Another big surprise can be finding out the plan sponsor is a member of a controlled group of businesses and as far as the IRS is concerned, all employees of all members of the controlled group must be considered potentially eligible for the plan.
8. Failure to limit salary deferrals to the 402(g) limits. IRC Section 402(g) limits the amount of salary deferral contributions an employee can make to a 401(k) plan each calendar year. It is our experience that 402(g) failures most often arise from payroll glitches. Example: allowing salary deferral contributions on bonus payments that are processed separately from customary payroll, so there is no combined 402(g) testing of amount deferred. If corrected in a timely fashion, excess 402(g) deferrals can be corrected without penalty.
9. Failure to follow the plan’s loan provisions, e.g., granting loans in impermissible amounts and with repayment schedules not consistent with the terms of the plan. This is a classic example of failing to follow the terms of the plan. Unless the plan explicitly allows participants (or beneficiaries) to borrow from the plan, then such loans are absolutely prohibited. If a 401(k) plan allows for participant loans, each loan must comply with applicable IRC limits and guidelines and must comply with any additional loan policy set by the plan itself. Plan sponsors frequently grant loans from plans that do not allow loans or set out repayment terms that are not consistent with the plan’s terms.
10. Failure to follow the plan’s hardship withdrawal terms. A participant may take a hardship withdrawal from a 401(k) plan only if the participant has no other financial source for meeting the hardship. In particular, the IRS has observed plan sponsors granting hardship withdrawals without first confirming the participant is not eligible for a participant loan. Another common failure is not requiring a participant who takes a hardship withdrawal to stop making salary deferral contributions for a period of time.
Suggestion for Items 4‐10: See 3 above.
This article was written by Alan J. Stonewall, FSPA, EA, MAAA. Mr. Stonewall is a former president of the American Society of Pension Professionals & Actuaries and former chairman and board member of the Actuarial Standards Board. He is a current board member of the Actuarial Foundation.
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This newsletter has been published in order to share general information with our professional contacts. The information presented in this newsletter should not be acted upon without first seeking the advice of a CPA, attorney or other benefit professional.