401(k) Compliance Reviews Help Avoid Compliance Mistakes
While 401(k) compliance reviews offer employers and their employees tax-favored opportunities to save for retirement, as tax-qualified retirement plans under the Internal Revenue Code (“IRC”) and covered by the Employee Retirement Income Security Act (“ERISA”), they are also subject to numerous legal compliance requirements under such laws. These requirements apply generally upon the plan’s establishment and throughout the plan’s term.
Accordingly, employers must review the 401(k) compliance review requirements to ensure ongoing plan compliance with applicable law. Such a review should be undertaken no less frequently than annually. Failure to comply with these 401(k) plan requirements can result in the disqualification of the plan under the IRC and the related loss of the favorable tax benefits associated with 401(k) plans, as well as the imposition of monetary penalties and liability.
Below, we have listed a couple of compliance requirements for operating a 401(k) plan that should be periodically reviewed.
Why would you benefit from a 401(k) Compliance Review?
Ensure Plan Operations Align with Written Terms
Failure to operate the plan in accordance with its written terms can result in loss of the plan’s qualified status and associated tax penalties or corrective actions. Such failures may cause participants to lose the tax-deferred benefits of their accounts and require the employer to make costly corrections. In addition, not following the plan document constitutes a breach of fiduciary duty under ERISA, which can lead to Department of Labor enforcement actions and personal liability for fiduciaries. This is why 401(k) Compliance Reviews are a must for any retirement plan sponsor.
Maintain Current and Compliant Plan Documents
Plan sponsors must ensure that plan documents are kept current and compliant with all applicable laws and regulatory updates. Outdated or incomplete documents can lead to loss of the plan’s qualified status, tax consequences, and compliance violations. Regular review and timely amendments help ensure the plan’s terms accurately reflect its current operations and protect fiduciaries from potential liability.
Adhere to the Plan’s Defined Terms for Compensation
Plan sponsors must adhere to the plan’s defined terms for “Compensation” when calculating contributions, performing testing, and determining eligibility. Using amounts outside the plan’s definition can result in operational errors, failed compliance tests, and potential corrective actions. Regular reconciliation between payroll records and plan provisions helps ensure accuracy and maintain the plan’s qualified status.
How a 401(k) Compliance Review Protects Your Plan
Comply With Applicable Contribution Nondiscrimination Tests.
401(k) compliance review are subject to special nondiscrimination tests applicable to elective salary deferrals (pre-tax and Roth contributions) on the one hand and to matching contributions and employee after-tax contributions on the other. These tests generally limit the contribution amounts allocated to higher-paid participants. Failure to promptly correct noncompliance with these nondiscrimination tests can result in additional tax penalties for the employer.
Ensure all Eligible Employees Have the Opportunity to Participate in the Plan.
Improperly excluding eligible employees from the 401(k) plan may result in “corrective additional contributions” made by the employer to the plan.
Ensure Elective Salary Deferral Contributions do not Exceed the Annual Limit.
Elective salary deferral contributions under all 401(k) compliance review are subject to an IRS-prescribed annual calendar year limit. For 2019, the dollar limit for elective salary deferrals to all 401(k) plans is $19,000. For participants aged 50 or older during 2019, the dollar limit for “catch-up” elective salary deferrals is an additional $6,000 (if the plan otherwise permits such catch-up contributions). These dollar limits are subject to annual adjustments by the IRS based on changes in the “cost of living.”
Timely Contribution of Elective Salary Deferrals to the 401(k) Plan.
Generally, under ERISA, elective salary deferrals must be deposited into the plan no later than the earliest date such amounts can reasonably be segregated from the employer’s general assets. A special safe harbor deposit timing rule applies to “small plans” (i.e., less than 100 participants as of the beginning of the plan year). Failure to timely deposit elective salary deferrals can result in a “prohibited transaction” under the IRC and ERISA.
Ensure Plan Loans are Property Administered.
While participants may borrow from their account under a 401(k) plan (if the plan permits loans), if such loans do not comply with legal requirements or are not timely repaid, the amount of such loan will be taxable to the participant.
Ensure “Hardship” Distributions are Properly Administered.
401(k) plans may allow participants to receive a distribution while employed if they have an “immediate and heavy” financial need that generally cannot be met from other available financial sources. Hardship distributions must be made in accordance with legally compliant plan terms and procedures. The regulatory rules for hardship distributions were recently revised and liberalized by the IRS.
Is a “Top-Heavy” Plan Minimum Contribution Required?
Suppose a 401(k) plan is a “top-heavy” plan (i.e., account balances for “key employees” exceed 60% of account balances for all participants). In that case, the plan will be subject to a minimum contribution requirement for all “non-key employees.” Top-heavy plan status is generally more common among small employer plans.
Timely Form 5500 Annual Reporting Requirement.
401(k) plans must file annual information returns (Form 5500 Reports) with the U.S. Department of Labor. The type of Form 5500 report and the scope of the report information required depends generally on the plan size (e.g., plans with 100 or more participants typically must include an independent plan auditor report with the Form 5500 filing). Failure to file Form 5500 reports promptly (generally by the end of the seventh month following the plan year’s end unless such filing due date is extended) can result in significant late filing penalties.
As you can see, 401(k) plans are subject to many legal compliance requirements, and failing to comply with such requirements can result in substantial costs and penalties. Accordingly, employers that sponsor 401(k) plans are strongly encouraged to periodically review their plans to ensure compliance with applicable legal requirements and the avoidance of plan-related liabilities.
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