Fixing Common Plan Mistakes - "Simple" Retirement Arrangements - SEPs, SARSEPs and SIMPLE IRA Plans

The Issue

Many of you make use of one of the “Simple” plans that are designed to be easy to establish and administer. A SEP is a Simplified Employee Pension plan. Employer contributions are made directly to an IRA set up for each employee. A SARSEP is a SEP established before 1997 that includes a salary reduction arrangement. A SIMPLE IRA plan may be adopted by small employers. Employees may choose to make salary reduction contributions and the employer makes matching or nonelective contributions to an IRA set up for each employee.

The Problems

Instead of covering just one failure, this issue will discuss some of the most common failures found with “Simple” IRA-based plans.

• Not updating the plans for new law, such as the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA).
• For SARSEPs, failure to pass the deferral percentage test.
• Under or over contribution of funds.

The Fix

The problems discussed will cause a plan to become disqualified, resulting in adverse tax consequences to the employer and employees under the plan; however, employers may get relief from these adverse consequences through the Employee Plans Compliance Resolution System (EPCRS) by correcting the failures. The Self-Correction Program (SCP) or Voluntary Correction Program (VCP) can be used to correct these mistakes. In order to fix the mistake under SCP, generally the mistake must be fixed within two years after the end of the plan year in which the failure occurred. Unless the failure can be classified as insignificant, VCP must be used after this time.

Failure to amend timely for new law can be corrected by adopting the necessary documents that bring the plan into compliance. Any participant benefit lost due to the failure must be restored. 

Failure to pass the deferral percentage test applicable to a SARSEP happens when the average percentage of deferrals made by highly compensated employees (HCEs) exceeds the average percentage of deferrals made by non-highly compensated (NHCEs) by more than 25%.

This failure may be corrected in one of the following ways:

1) Contributions that are 100% vested may be made to all eligible NHCEs (to the extent permitted by the law) necessary to raise the percentage needed to pass the test.

2) Excess contributions, adjusted for earnings, may be distributed to HCEs. An amount equal to the total amount distributed must be contributed by the plan sponsor and allocated to current or former employees who were NHCEs in the year of the failure.

If the failure involves under contributions, make-up amounts that are fully vested and adjusted for earnings would be made by the plan sponsor.  Generally, the earnings rate is based on the investment results that would have applied if the failure had not occurred.  If the actual investment results cannot be determined, a reasonable interest rate may be used.

Over contributions or excess amounts are treated differently based on how they occurred:

1) If they are due to elective deferrals, the excess amounts, adjusted for earnings, may be distributed to the affected participant, reported on Form 1099-R and are includible in gross income in the year of distribution. The affected participants must be notified that the corrective distribution is not eligible for favorable tax treatment (i.e., tax-free rollover).

2) If they are due to employer contributions, the excess amount, adjusted for earnings, may be distributed to the plan sponsor. The amount distributed is not includible in the gross income of the affected participant and the plan sponsor is not entitled to a deduction for the excess amount.  The distribution is reported on Form 1099-R issued to the participant indicating the taxable amount as zero.

If an excess amount is retained in the IRA-based plan:

1) A special fee, in addition to the VCP submission fee, will apply.

2) Generally, only excess amounts that did not result in a violation of a statutory limitation can be retained.

3) No deduction is allowed for an excess amount retained in the plan.

4) If the retained excess amount is due to contributions in excess of the legal maximum, the excess amount, adjusted for earnings, must reduce each affected participant’s limit for the year following the year of correction (or for the year of correction if the plan sponsor so chooses) and subsequent years, until the excess is eliminated.

5) If the total excess amount is $100 or less, it is not required to be distributed and the special fee will not apply.

Making Sure It Doesn’t Happen Again

Employers need to have a system in place to ensure that their IRA-based plans are updated timely for new law. Employers should work with plan administrators to ensure that the administrators have sufficient payroll information to verify that the proper deferrals and contributions are made to each participant. However, keep in mind that, despite all of your good efforts, mistakes can happen. In that case, the IRS can help you correct the problem and retain the benefits of your qualified IRA-based plans.