Employee Benefit Plans: The 411

Valuable Information on 401ks, Pensions, ESOPs, Form 5500 Preparation + More

Compliance Testing Failures – Now What?

Hearing the news of a compliance testing failure sounds rather daunting. The severity of a compliance testing failure varies by case, and correcting it may not be as difficult or costly as it sounds. Throughout compliance testing, traditional 401(k) plans must be tested to ensure that contributions made by and for nonhighly compensated employees (“NHCE”) are proportional to those made for and by highly compensated employees (“HCE”). These tests are referred to as Actual Deferral Percentage (“ADP”) and Actual Contribution Percentage (“ACP”) tests. There are parameters set for each test. A failure results from the ADP or ACP tests exceeding those parameters.

Correcting the error is the most vital step in the process. Corrective action described in your plan document must be taken within the statutory correction period following the close of the plan year; also an excise tax will be added to the liability if the correction is not made within the first 2 ½ months of the correction period. If the correction is not made within the 12 month statutory correction period, the plan may lose its tax-qualified status and the failure must be corrected by using the IRS Employee Plans Compliance Resolution System (“EPCRS”).

Using the EPCRS leaves you with three options for correction:

  1. Self-Correction Program – will permit a plan sponsor to correct the failure(s) without contacting the IRS or paying a fee
  2. Voluntary Correction Program – permits a plan sponsor to, any time before audit, pay a fee and obtain IRS approval for the correction of the plan failure(s)
  3. Audit Closing Agreement Program – allows a plan sponsor to pay a sanction and correct the plan failure(s) while the plan is under audit

The corrections will typically consist of a Qualified Non-Elective Contribution (QNEC) to raise the deferral percentage of the NHCE’s, or excess contribution amounts are determined and distributed to HCE’s with the same amount being contributed to the eligible NHCE’s.

In addition to the above options, a plan may refund excess contributions to the NHCE’s, beginning with those that have the highest amount of contributions for the plan year, and adjusting all NHCEs until the plan is compliant with the testing parameters. One negative attribute from a participant perspective is that the refunds are considered taxable income upon receipt, and will not be a portion of their retirement funds.

While implementing a Safe Harbor match will prevent such failures from happening, it is vital that plan sponsors monitor the results of such testing, or perform tests independently for additional assurance. Timeliness is key in correcting plan failures.

By Sarah McFarland