Our 401(k) plan allows new employees to make contributions on the first day of the quarter after they work for us for a year. All of our full-time employees have been with us for a long time. Most of our new hires are for short-term projects, so they almost always terminate employment in less than a year and never become eligible for our 401(k) plan. Recently, however, we had two new hires that did stay with us for a year and should have become eligible for the plan. One of them heard about the plan from a co-worker and submitted a deferral election form, but since we are not used to new hires sticking around that long, we overlooked implementing the election. The other never knew about the plan at all.
Do we have to correct the fact that these new hires were not properly enrolled in the plan?
The bad news is that this is considered an operational failure and must be corrected. The good news is that this is not an uncommon oversight, and the IRS has provided guidance on how to fix it.
This type of failure is referred to as a missed deferral opportunity or MDO, and there are 5 easy steps to the correction.
- Determine the amount the participant would have deferred had the error not occurred. This is the missed deferral opportunity.
- Calculate an employer Qualified Nonelective Contribution (“QNEC”) to compensate the participant for the MDO.
- Calculate any employer matching contribution associated with the MDO.
- Adjust items 2 and 3 for investment gains.
- Deposit the resulting amount into the participant’s plan account.
For the first step, the amount the participant would have deferred is based on his or her deferral election. In this case, one participant made an election, but the other did not. When there is no election on file, the IRS provides certain assumptions based on plan design and demographics.
The corrective QNEC is generally equal to 50% of the amount the participant would have deferred (from step #1); however, that can sometimes be reduced to 25%, depending on how quickly the error is caught and corrected, or maybe even 0% for certain automatic enrollment plans.
If the company made a matching contribution for the time frame that deferrals were not properly withheld, the match formula is applied as if the participant had been deferring. As long as this type of error is caught and corrected within 3 years, there is no requirement to file anything with the IRS or seek any type of approval. If it goes beyond 3 years, self-correction may still be possible if the overall failure is "insignificant" in nature.