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10 Common Retirement Plan Compliance Failures Found by the IRS

DWC 10/2/17

Contrary to what some people may think while writing out checks for penalty fees, the IRS  doesn't actually want to find compliance issues in retirement plans.

Proof positive is a published IRS list of the top 10 plan compliance failures found in voluntary correction filings. The list provides a great opportunity for plan sponsors to have experienced TPAs review their plans and prevent or correct these problems. Doing this work in advance of an audit can save time, money, and frustration. (See? The IRS doesn't really want to torment you.) 

Here are the top 10 compliance issues explained: 

1. Failure to Amend the Plan for Tax Law Changes by the End of the Period Required by the Law

All qualified plans are required to have a written plan documents describing their provisions. From time to time, Congress or a government agency, e.g. IRS or Department of Labor, will issue new rules or change existing ones. If these changes impact the language in the plan document, the plan must be amended to reflect the law change. These amendments do not follow a set schedule and deadlines vary, so it is easy to overlook deadlines.

The service provider that prepared your plan document should notify you when one of these so-called interim amendments is required. But whether you're signing the amendment or your document provider is signing on your behalf (it depends on what kind of plan you have), the IRS considers it your responsibility to maintain timely adopted copies of all interim amendments.

2. Failure to Follow the Plan’s Definition of Compensation for Determining Contributions

To put it simply, plan contributions must be based on compensation as defined in the written plan document. A common definition is the amount reported in box #1 of Form W-2, grossed up for any pre-tax deferrals to a 401(k) plan and/or a cafeteria plan. That is essentially gross compensation, so failure to consider that cash bonus handed out at the company holiday, for example, party runs afoul of this definition.

To minimize compensation errors, start by working with your payroll provider to confirm that the various pay codes they use in their system are consistent with your plan document. It is much easier to take these steps at the beginning than to calculate corrective contributions on incorrectly excluded compensation years in the future.

3. Failure to Include Eligible Employees in the Plan or the Failure to Exclude Ineligible Employees From the Plan

There are a number of details that can complicate matters when it comes to plan eligibility. These errors often arise due to a misunderstanding of the eligibility provisions.

For example, if a plan provides for immediate eligibility, your employees’ high school and college kids who come to work part time over the summer are eligible for the plan. Although they probably wouldn’t make contributions anyway, if they are not given the opportunity to enroll, they are treated as being improperly excluded, and the company must contribute on their behalf to correct the error.

It is also a problem to include someone the plan or the law says should be excluded. A newly hired executive cannot be allowed to join the plan right away if the eligibility requirements specify a one-year waiting period.

4. Failure to Satisfy Plan Loan Provisions

The loan rules are complex and rigid. Regulations limit the amount, duration and payment terms for participant loans, and even the slightest misstep creates a compliance failure. Even worse, loan errors cannot be self-corrected; any corrections must be submitted to the IRS for formal review and approval, which can be a costly undertaking. 

Another aspect that is fraught with complexity is refinancing, which includes any change to any of the terms (amount, interest rate, amortization period) of an existing loan. Many plans do not permit refinancing. For those that do, there are specific rules that apply. 

A loan that does not follow the rules or remain within the prescribed limits is treated as taxable distribution to the participant in question. 

5. Impermissible In-Service Withdrawals 

A plan document will specify whether and under what conditions in-service withdrawals are permitted. For example, a plan may offer hardship distributions and/or other in-service distributions on attainment of age 59 ½. However, there are additional restrictions. IRS rules provide a “safe harbor” definition of what constitutes a financial hardship, and many plans incorporate that definition.

In addition, there are legal restrictions on money types that are available for in-service distributions. Safe harbor 401(k) contributions cannot be withdrawn during employment prior to age 59 ½ even if the plan otherwise permits hardship distributions. Amounts attributed to money purchase pension plans or defined benefit plans are not available before age 62.

6. Failure to Satisfy the Rules Related to Required Minimum Distribution Rules (RMDs)

Once a participant reaches age 70 ½, he is required to take a distribution of a portion of his account each year. The amount is based on the participant’s account balance and IRS life expectancy tables. Failure to timely take an RMD subjects the participant to an excise tax equal to 50% of the RMD.

Since RMDs are based on account balances at the end of the preceding year, it is a good idea to notify participants early in the year if they are required to take a distribution. This gives them adequate time to submit any necessary paperwork so that the RMD can be processed well before the deadline.

7. Employer Eligibility Failure

Certain types of businesses are eligible to sponsor certain types of plans. Perhaps, the most obvious example is that only not-for-profit organizations and certain governmental entities (such as public schools) can sponsor 403(b) plans; while for-profit organizations cannot. Similarly, many government entities cannot sponsor 401(k) plans.

8. Failure to Pass the ADP/ACP Nondiscrimination Test

It is actually not a problem to fail the ADP/ACP test as long as that failure is corrected by the end of the following year. In other words, a calendar year plan that fails the ADP test for 2017 has until December 31, 2018, to correct the failure.

If the failure is not corrected within the one-year timeframe, the plan’s tax-favored status is in jeopardy. It is still possible to correct, but the options become much more restrictive and expensive.

One way to minimize the likelihood of this eventuality is to provide your employee census information to the service provider that prepares your testing as soon as possible after the end of the year. This gives them time to review your information, perform the tests and advise you of any corrective actions while there is still plenty of time to implement them.

9. Failure to Provide the Minimum Top-Heavy Benefit to Non-Key Employees

When more than 60% of plan assets are in the accounts of certain owners and officers (known as key employees), the plan is top heavy. Top-heavy plans must provide contributions to non-key employees, generally up to 3% of their compensation, no later than the end of the following year.

Sometimes, a plan sponsor will fail to provide these contributions, because they do not realize they are required to do so. Safe harbor 401(k) plans can be particularly vulnerable. 

In addition, there can be misunderstanding in plans that do not otherwise provide for any company contributions. However, even deferral-only plans can become top heavy, triggering the required company contribution.

10. Failure to Cap Benefits at the Annual Additions Limit

In a defined contribution plan, a participant’s total contributions for a given year are limited to the lesser of $51,000 (indexed for inflation) or 100% of compensation. Due to the higher limits, this failure is less common that it used to be; however, it does still arise occasionally, especially when the goal of a plan is to maximize one or a group of employees.

Although there are mechanisms in place to correct excess annual additions, plan sponsors should avoid the temptation to intentionally “force” an excess allocation, knowing it can be corrected, to accomplish some other objective.

What to do with all this information? By paying attention to the items on the list, you're already off to a good start.

To really shore up your retirement plan, contact us today. DWC can not only help develop internal processes and procedures to minimize the likelihood that these errors will occur, but we can also help correct any operational oversights that are already in the books. 

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Topics: DWC, Plan Compliance, Plan Correction


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The views expressed in this blog are those of the authors and do not necessarily represent the views of any other person or organization. All content is provided for informational purposes only and is not intended to be tax or legal advice.