CASE OF THE WEEK – 401(k) Excesses

By Jenny Kiffmeyer, J.D – The Retirement Learning Center

401(k) Excesses

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare.  We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with an advisor in Minnesota is representative of a common inquiry regarding 401(k) plan nondiscrimination testing. The advisor asked, “I’m confused about the deadlines for correcting 401(k) plan excesses. Can you give me quick tutorial?”

Highlights of Discussion

I’ll try my best to summarize, generally, but be sure to seek out tax and/or legal advice for actual plan situations. One of the characteristics that sets 401(k) plans apart from other defined contribution plans are the unique contribution limits that apply to employee salary deferrals and matching contributions, namely the actual deferral percentage (ADP) limit, the actual contribution percentage (ACP) limit, and the IRC Sec. 402(g) annual deferral limit.

I’ll cover the three following excesses in this space:

  1. ADP failures—where the highly compensated employees (HCEs) defer too much in relation to the nonHCEs and create “excess contributions” [IRC Sec. 401(k)(8)(b)]
  2. ACP failures—where matching and/or after-tax contributions are too high for HCEs in relation to those for nonHCEs and create “excess aggregate contributions” [IRC Sec. 401(m)(6)(B)]
  3. 402(g) failures—where plan participants, either HCEs or nonHCEs, defer above the annual limit and create “excess deferrals” [IRC Sec. 402(g)(3)]

401(k) Excess Correction Deadlines

Type of 401(k) Excess Time of Correction Consequences of Failing to Timely Correct
Excess Contributions (ADP test failure where HCEs defer too much compared to nonHCEs)

Or

Excess Aggregate Contributions (ACP test failure where HCEs’ matching and or after-tax contributions are too high compared to nonHCEs’)

Within 2½ months after plan year end (March 15th for a calendar year plan)

Issue corrective distributions to affected HCEs

Excess and earnings taxed in the year distributed

After 2 ½ months after plan year end

Two Corrective Options:

  1. Issue corrective distributions to HCEs

or

2. Make a Qualified Nonelective Contribution/Qualified Matching Contribution to correct the failure

  • Excess and earnings taxed in the year distributed
  • Employer subject to a 10% penalty tax

After the end of the plan year following the year of the excess

  • Employer subject to a 10% penalty tax
  • Potential for plan disqualification
  • Correct through Employee Plans Compliance Resolution System (EPCRS)
If “eligible automatic contribution arrangement” Excess Contribution or Excess Aggregate Contribution

6 months following the end of the plan year (June 30 for calendar year plan)

Issue corrective distributions to affected HCEs

Excess and earnings taxed in the year distributed

After 6 months following the end of the plan year

Two Corrective Options:

  1. Issue corrective distributions to HCEs or
  2. Make a Qualified Nonelective Contribution/Qualified Matching Contribution to correct the failure
  • Excess and earnings taxed in the year distributed
  • Employer subject to additional 10% penalty tax

After the end of the plan year following the year of excess (December 31 for calendar year plan)

  • Employer subject to additional 10% penalty tax
  • Potential for plan disqualification
  • Correct through EPCRS
Excess Deferrals (402(g) failure, Pre-Tax and Designated Roth)

On or before April 15th of year after deferral

Issue corrective distributions of excess deferrals, plus their earnings

  • Excess deferral taxed as income in the year deferred.
  • Earnings on excess taxed in the year distributed.

After April 15 of year following excess

  • Excess deferral taxed in the year deferred.
  • Both the excess deferral and earnings taxed in the year removed.
  • If excess deferrals result from deferrals to one or more plans maintained by the same employer, possible loss of qualified plan status

Amounts in excess of any one of these limits could have serious consequences for the employer, the participant and/or the plan as a whole. Plan penalties are costly to plan sponsors and every effort should be made to avoid them. But worse than paying the IRS an extra penalty fee is the potential loss of qualified status for the 401(k) plan. If the IRS disqualifies a plan, the plan sponsor loses the tax-saving benefits of the plan, and the assets become immediately taxable to the participants. Therefore, such excesses must be avoided and timely corrected when failures occur.

Conclusion

Treasury regulations contain clear steps and deadlines by which plan sponsors must correct 401(k) excesses. If done so timely, the plan sponsor can avoid additional penalties and potential plan disqualification. Corrections made after the specified deadlines must follow the terms of the IRS’s EPCRS.

Pattern

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