In 2023, PriceKubecka performed over 400 401(k) audits. And when it comes to plan errors, we’ve seen it all! After late deposits,
the most common error we saw was eligible compensation exclusions or inclusions.
Unlike late deposits, eligible compensation errors aren’t always clear–cut, and they can be complicated to fix. But the good news is these miscalculations are easy to resolve for future years and audits.
Issues with Eligible Compensation
When a company creates a 401(k) retirement plan, a key factor is the types of compensation that will be considered when determining peoples’ deferrals, employer matching, and discretionary contributions. When you hear the term ‘employee compensation,’ most business owners only think about wages/salaries. But what about overtime pay? How about bonuses, commissions, tips?
If your employee wants 4% of their wages to go into their retirement account, does he/she have a clear understanding of what’s considered wages? For that matter, does your payroll or HR department understand?
The most common problems arising from not following the plan’s definition of eligible compensation are overstatements or understatements in participants’ accounts due to improperly excluding or including amounts for deferrals and allocations. There is a plethora of reasons why plan rules aren’t being followed – improper pay codes, changing payroll providers, employee turnover, etc. But ultimately it comes down to how the payroll system is set up and whether administrators are aware of what their definition of eligible compensation is in their plan.
Failing to withhold deferrals from eligible plan compensation is considered an operational error referred to as a Missed Deferral Opportunity (MDO). Essentially, plan participants missed an opportunity to defer. You may be able to fix it using a corrective contribution. The affected employee would receive a corrective, qualified non-elective contribution (QNEC) that’s equal to 25%-50% of the missed deferral amount, along with 100% of the employer’s missed match and any lost investment earnings.
How quickly you attempt fix the exclusion error will determine if you’ll be responsible for 25% or 50% of the missed deferral. The longer you take to address the issue, the more likely you’ll be required to pay 50%.
Now there is an added layer on how to proceed with the correction. As the plan sponsor you may be eligible for self-correction without IRS approval. The general rule is that if an operational failure is caught and corrected within two years, it can be self-corrected. PriceKubecka always recommends you work with your service providers to ensure proper correction.
If your company has been missing deferrals for years or decades, you should work with an ERISA attorney to determine the most appropriate form of plan correction.
It’s a bit easier to address compensation that was improperly included in an employee’s deferral. Sometimes it is possible to create a retroactive amendment to your company’s 401(k) plan documents. Another way to resolve incorrect inclusions is to take the excess amount out of the employee’s account and return it to them (the affected participants).
Which option is best, amending the plan or returning the funds? It depends on facts and circumstances. Once again, you should make this decision with the help of your service providers.
Fix Eligible Compensation Issues for Good
In this case, a little bit of effort can go a long way! Here’s our suggestions for preventing improper inclusions and exclusions in the future.
- Consider simplifying your 401(k) plan’s definition of compensation and use that same definition across all contribution types.
- Don’t let the 401(k) plan be an afterthought! Keep the plan’s eligible compensation rules in mind when making any type of payroll change.
- If you add a new pay code, make sure you understand where it falls under the definition of eligible compensation before you start using it.
- Quarterly or semi-annual audits of your payroll reports to look at all the wage codes. Look for anomalies and ensure that your calculations are correct.
- We can’t stress training enough! At least once a year make sure everyone involved with payroll understands the rules when it comes to calculating deferrals.
PriceKubecka is your 401k audit expert.
Did this error appear in your 401(k) audit? Would you like our help in preventing these errors next year? Please CONTACT US. At PriceKubecka, it’s our mission to ensure clients have a better audit experience. Our 401(k) experts can answer your questions about eligible compensation, as well as any other plan error your audit identified.