Fixing Common Plan Mistakes - Compensation Errors in Defined Contribution Plans
The amount an employer contributes to a 401(k) or other type of defined contribution plan is based on the compensation paid to employees. Compensation is defined in the plan. If an incorrect amount of compensation is used to determine contributions, the contributions will be incorrect. This will cause an operational failure (failing to follow the terms of the plan in its operation).
Your plan document (or adoption agreement if you use a pre-approved plan) may have multiple definitions of compensation, including definitions for purposes of calculating:
- salary deferrals,
- matching contributions, and
- discretionary contributions.
The plan is not required to use the same definition of compensation for all contribution types. For example, a plan may allocate discretionary contributions based on an employee’s base salary only, while salary deferral contributions may be based on all forms of compensation including bonuses, commissions and other pay.
Errors related to compensation can occur when:
- the third party administrator or payroll processor does not know the plan’s definition of compensation;
- the plan’s definition of compensation is amended, but the third party administrator or payroll processor is not notified;
- payroll systems are not updated to reflect the revised definition; or
- payroll systems are not updated when the types of compensation paid change.
Fixing the Problem
Contribution errors caused by incorrect compensation figures can be corrected using IRS retirement plan correction programs -- known as the Employee Plans Compliance Resolution System (EPCRS) and outlined in Revenue Procedure 2008-50.
The error can be self-corrected, without IRS approval, if the mistake is insignificant or, if significant, if the plan sponsor corrects the mistake within two years. A plan sponsor can use self-correction only if the plan has practices and procedures in place designed to promote overall tax law compliance.
Voluntary Correction Program
Plan sponsors can correct errors with IRS approval by using the Voluntary Correction Program.
Your submission to the VCP should:
- describe the plan failure and proposed correction method,
- show calculations for your proposed corrective contributions, and
- state your proposal for fixing the administrative practices that allowed the failure to happen.
Appendix D of Rev. Proc. 2008-50 may be used for your VCP submission.
Your correction method should put the participants in the position they would have been had the failure not occurred. You may need to make corrective contributions for participants or you may need to distribute excess amounts from the plan.
Compensation that should have been excluded
Including too much compensation to determine plan contributions will result in excess employer contributions. To correct the excess, the plan sponsor should:
- distribute excess elective deferrals, plus earnings, to each affected participant, and
- forfeit excess discretionary contributions according to the method required by the plan document. The plan terms will require the sponsor to either:
- reallocate the forfeitures to plan participants based on the correct compensation, if appropriate, or
- hold the forfeitures in an unallocated account to reduce future plan contributions.
Employer Z sponsors a 401(k) plan for its employees. The plan amended its definition of compensation to exclude bonuses for making deferrals and allocating other contributions, effective in 2009. For the 2010 plan year, Employer Z did not exclude bonuses from compensation in determining deferrals and allocations. Three of Z’s employees had base compensation of $120,000 and a $30,000 bonus. Each of these employees had deferral percentages of 6% of compensation and Z made a discretionary profit-sharing contribution of 5% of compensation to each participant’s account. The plan document provides that forfeitures will be used to offset future employer contributions.
- Each of the three employees properly deferred 6% of their $120,000 base compensation ($7,200), but improperly deferred 6% of the $30,000 bonus ($1,800).
- Each of the three employees properly received a profit-sharing allocation equal to 5% of their $120,000 compensation ($6,000) but improperly received an allocation equal to 5% of the $30,000 bonus ($1,500).
- Excess salary deferrals - The plan should distribute the improper salary deferrals of $1,800, plus earnings, to each of the three employees.
- Excess discretionary contributions - Each of the three employees should forfeit the excess discretionary contributions of $1,500, plus earnings. These forfeitures can be placed in an unallocated account to use for nonelective contributions in future plan years, according to the terms of the plan.
Compensation that should have been included
If you erroneously omitted some forms of compensation from elective deferrals, matching or discretionary contributions, you should make corrective contributions for the affected participants.
- Missed salary deferrals
Multiply the amount of the omitted compensation by the deferral percentage that the employee specified in his salary reduction agreement. This is the employee’s “missed deferral.”
50% of the missed deferral is the employee’s “missed deferral opportunity.”
Contribute this amount to the employee’s account, plus earnings through the date you make your corrective contribution.
- Missed matching contributions
If you agreed to match all or part of the employees’ elective deferrals, make a matching contribution based on the missed deferral, plus earnings through the date of correction.
Do not base matching contributions on 50% of the missed deferral (the “missed deferral opportunity”). Matching contributions must be based on the full missed deferral.
- Missed discretionary contributions
If you made discretionary contributions to participants for the plan year, contribute the same percentage of the omitted compensation as was contributed with respect to the compensation that was properly included, plus earnings through the date of correction.
You do not have to reduce the account balances of employees who may have received greater allocations of employer contributions than they would have received had the compensation error not occurred.
You may choose to reallocate contributions to reflect the allocations that would have been made had the error not occurred.
Employer Z sponsors a 401(k) plan for its employees. The plan includes bonuses and commissions in its definition of compensation for deferrals and allocations. Three of Z’s employees received bonuses of $30,000 in 2010. Each of these employees had deferral percentages of 6% of compensation. The plan provides for a 100% matching contribution on the first 4% of deferrals, and Z decided to make a discretionary contribution of 5% of compensation for each participant. Z did not withhold deferrals from the bonus checks or include the bonuses in its matching or discretionary contribution allocations.
- Each of the three employees had a missed deferral of 6% of their $30,000 bonus ($1,800).
- The missed deferral opportunity for each employee was 50% of their missed deferral ($900). Z should contribute this amount to each employee’s account.
- Each employee should have received an additional matching contribution of 4% of the $30,000 omitted compensation ($1,200). The matching contribution is based on the full missed deferral, and not on the lower missed deferral opportunity ($900).
- Each employee should receive a 5% discretionary contribution for the $30,000 omitted compensation ($1,500).
Corrective contributions should reflect earnings
Corrective contributions should be increased to reflect earnings through the correction date based on the participant’s own investment results.
Making Sure it Doesn’t Happen Again
- Perform an annual review of your plan’s operations to ensure that contributions are made based on the correct definition of compensation.
- When you amend or restate your plan, check its compensation definitions against the old plan document, noting any differences.
- If you start to pay a new type of compensation, such as bonuses or overtime, check your plan language to confirm its proper treatment, and then tell your payroll processor or third party administrator about it.
- If possible, simplify your plan’s definition of compensation and use the same definition for multiple purposes.