401(k) Plan Review Help Avoid Compliance Mistakes
Additional Information
While 401(k) plans offer tax-advantaged retirement savings for both employers and employees, they are also subject to strict compliance requirements under the Internal Revenue Code (IRC) and ERISA. These requirements apply from the plan’s establishment and continue throughout its existence, making regular compliance reviews essential.
Employers must ensure their 401(k) plans comply with legal standards, conducting a review at least annually. Non-compliance can result in the disqualification of the plan under the IRC, leading to the loss of tax benefits and potential penalties or liabilities.
Here’s a checklist of key compliance requirements that should be reviewed periodically:
Timely Plan Amendments: 401(k) plans must be updated to reflect changes in the law (e.g., statutory or regulatory updates) and any optional changes, like adjusting contribution levels. Changes to the plan document also often require updates to the Summary Plan Description (SPD) or Summary of Material Modifications (SMM).
Operate the Plan According to Its Terms: The plan must be operated in accordance with its written terms to avoid adverse tax consequences and fiduciary breaches.
Proper Definition of “Compensation”: The plan must have an accurate definition of compensation, as it is crucial for calculating contributions and ensuring compliance with nondiscrimination testing under the IRC.
Confirm Applicable Employer Matching and Nonelective Contributions are Timely and Properly Allocated to Eligible Participants.
Comply With Applicable Contribution Nondiscrimination Tests.
401(k) plans must undergo special nondiscrimination tests that apply to both elective salary deferrals (pre-tax and Roth contributions) and matching contributions or employee after-tax contributions. These tests are designed to ensure that contributions are fairly distributed among employees, particularly limiting higher allocations to higher-paid participants.
Failure to promptly correct any noncompliance with these tests can lead to additional tax penalties for the employer, making it essential for employers to regularly monitor and adjust the plan to maintain compliance.
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 to 401(k) plans are subject to an IRS-prescribed annual limit. For 2019, the limit for elective deferrals was $19,000 across all 401(k) plans. Participants aged 50 or older in 2019 could contribute an additional $6,000 as a “catch-up” contribution, provided the plan allows it.
These limits are subject to annual adjustments by the IRS, which are based on changes in the cost of living. It’s important for plan sponsors to stay updated on these changes to ensure compliance.
Timely Contribution of Elective Salary Deferrals to the 401(k) Plan.
Under ERISA, elective salary deferrals must be deposited into the plan as soon as they can reasonably be separated from the employer’s general assets. A special safe harbor deposit timing rule applies to “small plans” (i.e., those with fewer than 100 participants at the beginning of the plan year).
Failure to deposit elective salary deferrals in a timely manner can result in a “prohibited transaction” under both the IRC and ERISA, leading to potential penalties and compliance issues for the employer.
Ensure Plan Loans are Property Administered.
Participants in a 401(k) plan may borrow from their account if the plan allows loans. However, if these loans do not comply with legal requirements or are not repaid on time, the outstanding loan balance becomes taxable to the participant. This could result in additional taxes and penalties, so it is important to ensure loans are properly structured and repaid according to the plan’s rules.
Ensure “Hardship” Distributions are Properly Administered.
401(k) plans may permit participants to receive a hardship distribution while still employed if they experience an “immediate and heavy” financial need that cannot be met from other available financial resources. These distributions must comply with the plan’s legally compliant terms and procedures. Recently, the IRS revised and liberalized the regulatory rules for hardship distributions, making it easier for participants to access funds in cases of severe financial hardship. It’s important for plan sponsors to ensure that the plan’s hardship distribution rules are in line with these updates.
Is a “Top-Heavy” Plan Minimum Contribution Required?
If a 401(k) plan is considered “top-heavy”—meaning the account balances of key employees exceed 60% of the total account balances for all participants—the plan will be subject to a minimum contribution requirement for all non-key employees. This ensures that non-key employees are adequately supported, even in a top-heavy plan. Top-heavy status is more commonly found in small employer plans, as they may have a higher concentration of assets held by key employees.
Timely Form 5500 Annual Reporting Requirement.
401(k) plans are required to file annual Form 5500 reports with the U.S. Department of Labor. The type of report and the scope of information needed depend on the plan’s size. For example, plans with 100 or more participants generally must include an independent audit report with their Form 5500 filing. Failure to file these reports on time—usually by the end of the seventh month after the plan year ends, unless an extension is granted—can result in significant late filing penalties.
As demonstrated, 401(k) plans face numerous legal compliance obligations, and non-compliance can lead to substantial penalties and costs. Therefore, it is crucial for employers sponsoring 401(k) plans to regularly review their plans to ensure they meet all applicable legal requirements and avoid plan-related liabilities.
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