A common mistake found in retirement plan audits is the incorrect usage of the plan’s definition of compensation. This can quickly lead to participants contributing too much or too little into their accounts. Mistakes should be corrected as soon as they are identified. This involves identifying (1) the pay codes that should or should not be included in the contribution calculations based on how the plan document defines eligible compensation, (2) the participants and plan years impacted, and (3) whether a corrective contribution, reallocation, or distribution should be made.
Below is an overview of corrections to be made when compensation codes are improperly included or excluded from contribution calculations per the IRS 401(k) Fix-It Guide. However, plan sponsors should consider consulting their third-party administrator or an ERISA attorney depending on the severity of the problem.
The following was excerpts were taken from the IRS 401(k) Fix-It Guide at https://www.irs.gov/retirement-plans/401k-plan-fix-it-guide
If you have determined that an employee made excess elective deferrals, give the participant a distribution of the excess deferrals plus earnings. However, if net earnings are negative then the plan sponsor will need to make an additional contribution to the participant’s account to reimburse it for the loss.
In addition, matching contributions related to the excess deferral (adjusted for earnings) should be forfeited and based on plan terms, either reallocated to other participants or to an unallocated account to be used for future matching contributions.
If there are improper profit-sharing contributions, forfeit and based on plan terms reallocate the contributions plus earnings to plan participants or to an unallocated account to be used to be used for future profit-sharing contributions.
Deferrals Not Enough
If you’ve determined that an employee made deferrals that were less than what should have been made had the correct compensation amount been used, then a corrective contribution needs to be made to the employee’s account within the plan. The employee would receive a corrective qualified non-elective contribution (which is an employer contribution in which the employee is fully vested) equal to 50% of the missed deferral (i.e., the difference between the amount that should have been deferred based on the use of correct compensation and what was deferred).
In addition, the employee would receive a corrective employer matching contribution, if applicable, equal to the difference between what the employee would have received if the correct elective deferral was made and the actual matching contribution.
Finally, the employee would receive a corrective employer contribution to the extent that he or she received a profit-sharing allocation that was less than what he or she would have been entitled to had the correct compensation been used. All corrective contributions must be adjusted for earnings.
Plan sponsors may not have historically experienced issues with plan compensation, but as new pay codes are added, errors can arise. Therefore, it is important to perform annual reviews of compensation definitions and ensure contributions are properly including or excluding pay types based on the plan document. This annual review will help prevent errors or will help identify problems early lessoning the complexity of the corrective action.
Do you have any questions? Please don’t hesitate to contact a Henry+Horne professional to assist you.