When Opportunity Doesn't Knock
There are a lot of moving parts in 401(k) plans, and it is not uncommon for the occasional “oops” to occur. One of the most common is what is referred to as a missed deferral opportunity or an MDO. In a nutshell, that is when an employee who is supposed to have the opportunity to defer, for whatever reason, is not allowed to do so. These are situations when 401(k) deferrals are not even withheld from the employee’s paycheck as opposed to when deferrals are withheld but not deposited on time.
Fortunately, MDO mistakes are pretty straight-forward to correct, and the IRS has provided a road map for doing so in a formal correction program called the Employee Plans Compliance Resolution System (EPCRS).
How Missed Deferral Opportunities Occur
Although there are any number of scenarios that can lead to a missed deferral opportunity failure, the three most common are as follows:
Implementation Error: A participant makes an election to contribute to the 401(k) plan, but that election is either not implemented timely or at all.
|An employee submits an election to have 5% of his or her pay deducted and contributed to the 401(k) plan beginning on April 1st. Due to an oversight, that election is not implemented.|
|Eligibility Error: An employee who has met the plan's eligibility requirements is not timely given the opportunity to make a deferral.||An employee is first eligible for the plan on January 1st but is not given the opportunity to make 401(k) deferrals until April 1st.|
|Compensation Error: An incorrect definition of compensation is used to calculate a participant's deferrals.||Plan provisions indicate that total compensation is to be used, but operationally deferrals are not calculated on bonus payments.|
IRS Correction Methodology
The IRS maintains a program that allows plan sponsors to voluntarily correct certain oversights in plan management. This program is called the Employee Plans Compliance Resolution System (“EPCRS”), and it includes several pre-approved options for correcting missed deferral opportunities. The specific options that are available vary depending on plan features (such as the existence of an automatic enrollment provision) and the length of time that transpired from the initial missed deferral until the correct deferral withholding is initiated.
In general, the correction of an MDO consist of five steps:
- Determine the amount the participant would have deferred had the error not occurred. This is the missed deferral opportunity (“MDO”).
- 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.
Additional details about each of these steps are provided below.
Determining the Missed Deferral Opportunity ("MDO")
Since it would be impractical to ask a participant after the fact how much he or she would have deferred, the IRS has provided guidelines for determining the amount of missed deferral opportunity based on whether or not the participant actually filed a deferral election that wasn’t implemented and the specific plan features.
If the participant made a specific deferral election, then the MDO is calculated using the actual amount elected. If the affected participant(s) did not make elections, the MDO is determined as described in the chart below:
|Description||Missed Deferral Opportunity|
|Traditional 401(k) Plan||Average deferral rate of participant's group: Highly-Compensated Employee or Non-HCE|
|403(b) Plan||Greater of 3% of the deferral rate subject to 100% match|
|Catch-Up||50% of catch-up limit in effect for the year of the failure|
|Safe Harbor Match||Greater of 3%of the deferral rate subject to 100% match|
|Automatic Enrollment Safe Harbor (QACA)||Based on automatic deferral escalation schedule|
|Automatic Enroll (Non-QACA)||Greater of the default deferral rate or the average rate of the participant's group|
Calculating the Corrective Qualified Nonelective Contribution ("QNEC")
The amount of QNEC the company is required to make to correct the MDO depends on the amount of time that has elapsed between the initial missed deferral and the date the participant’s deferral election is properly implemented.
How Much is the Corrective QNEC?
When there is an MDO error, the affected participants receive the full amount of their compensation. That means if the corrective QNEC was equal to full amount of the missed deferral, the participants would receive a windfall. As a result, the QNEC is meant to compensate participants for the missed tax benefits they would have received if deferrals had been properly withheld.
The QNEC percentage is either 0%, 25% or 50% of the MDO, depending on the timing:
- Within 3 months: If the correct deferral withholding begins by the first pay period after 3 months from the initial missed deferral, then no corrective QNEC is required.
- Within 2 plan years: If the correct deferral withholding begins beyond 3 months but before the end of the second plan year following the year in which the first missed deferral occurred, the corrective QNEC is equal to 25% of the MDO.
- More than 2 plan years: If the correct withholding begins more than 2 plan years following the date of the initial missed deferral, the corrective QNEC is equal to 50% of the MDO.
Plans that include an automatic enrollment provision have an extended period of time to take advantage of the reduced corrective QNEC. In such plans, as long as the correct deferral withholding begins no later than 9 ½ months following the year in the which the failure occurred, then no corrective QNEC is required.
There are two additional requirements that apply in order to utilize the reduced QNEC (either 0% or 25%).
First is that if the participant comes forward and notifies the company of the oversight, the company must begin withholding the correct deferrals as soon as possible, but no later than the first pay period following the end of the month after the month in which the participant notifies the company. Failure to do so requires the company to make a correction QNEC of 50% of the MDO even if they would otherwise be eligible for a reduced QNEC.
For example, if the initial missed deferral occurred on March 1st and the employee notified the company on March 15th, correct deferrals must start no later than the first pay check that falls on or after April 30th (the end of the month after the month the employee notified the company of the error).
The second requirement is that the company must provide the affected participant(s) with a written notification of the failure within 45 days of the date that the correct deferral withholding begins. While there is no specific format for the notice, it should include the following points:
- The percentage of eligible compensation that should have been deferred (or the flat dollar amount if that is what the participant elected);
- The date deferrals should have begun;
- A statement that the correct deferral withholding has been implemented;
- A statement that applicable corrective contributions will be/have been made (specific amount not necessary);
- An explanation that the participant can adjust his or her deferral election to make up for the missed deferral opportunity; and
- The name of the plan and contact information for any questions.
Employers who do not wish to provide this notification are not eligible for the reduced QNEC and must instead use the 50% rate.
Calculating the Corrective Matching Contribution
Regardless of the rate of the corrective QNEC (0%, 25% or 50%), the company must calculate any missed matching contribution using 100% of the missed deferral opportunity amount.
How Much is the Corrective Match?
If a participant has a missed deferral opportunity equal to 4% of pay, the required corrective QNEC would be equal to either 0%, 1% of 2% of pay, depending on the timeframe involved as described above. However, in determining the correction for any missed matching contributions, the plan’s match formula is applied assuming this participant deferred the full 4% MDO amount.
Although this portion of the correction is meant to compensate the participant for a missed matching contribution, IRS rules indicate that it must be deposited to the plan as a nonelective (a/k/a profit-sharing-type) contribution.
Adjusting Corrective Contributions for Investment Gains
As a general rule, any time corrective contributions are required, those amounts must be increased by the investment gains the participant would have received had the error never occurred. Loss adjustments are optional. While any such loss adjustments would reduce the overall amount of the correction, the costs associated with determining those loss amounts often exceed any savings the company might realize.
How Are Missed Investment Gains Calculated?
If the affected participant had an account in the plan during the period of the error, that participant’s actual rate of return should be used. If the participant did not have an account but made an investment election, then the published rate(s) of return for the fund(s) selected should be used.
Absent a participant account or investment election (or if data is not available), there are several other options available:
- Rate of return for the plan as a whole;
- Department of Labor’s online calculator; or
- Rate of return for the plan’s default investment (considered a safe harbor method for automatic enrollment plans).
Depositing Corrective Contributions into the Plan
Once all the calculations are complete, the corrective contributions should be deposited into the participant’s plan account as soon as possible. If an affected participant does not have an account, one should be established for him or her.
To the extent the plan does not already have QNEC and/or Nonelective sources setup on its recordkeeping system, those sources should be created prior to or in conjunction with the deposit so that the corrective amounts can be tracked appropriately.
It is important to note that even though amounts in the plan’s forfeiture account can generally be used to offset company contributions, forfeitures cannot be used to fund QNECs of any type, including corrective QNECs. Forfeitures can, however, be used to fund match-related corrective contributions.
Even though the process to correct an MDO mistake is pretty straight-forward, the calculations are still quite detailed. Also, depending on how long ago the mistake occurred and/or the amount of money and participants involved, the IRS may want to review the correction to sign-off that it was all done correctly.
If you think your plan might have an MDO in need of correction, give us a call and we can work through the process on your behalf.