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401(k) Plan Fix-It Guide - Eligible employees weren't given the opportunity to make an elective deferral election (excluding eligible employees).

Mistake

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Fix the Mistake

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6) Eligible employees weren't given the opportunity to make an elective deferral election (exclusion of eligible employees). Review the plan document sections on eligibility and participation. Check with plan administrators to determine when employees are entering the plan. Make a qualified nonelective contribution for the employee that compensates for the missed deferral opportunity. Monitor census information and apply participation requirements.

Your 401(k) plan document should contain a definition of “employee” and provide requirements for when employees must become plan participants eligible to make elective deferrals. Employers sometimes assume the plan doesn't cover certain employees, such as part-time employees. Similarly, employees who elect not to make elective deferrals are often mistakenly treated as ineligible employees under the plan when other plan contributions are made and tests run. To reduce the risk of omitting eligible employees, you should ensure the accuracy of employee data such as dates of birth, hire and termination; number of hours worked; compensation for the year; 401(k) election information and any other information necessary to properly administer the plan.

Generally, treat each employee who receives a Form W-2 as an eligible employee unless you can properly exclude that employee by the plan terms. Using the plan definition of eligible employee with the plan age and service requirements, determine each employee’s eligibility. If you use leased employees, contract labor or have shared ownership of other enterprises, determining eligible employees can be complicated.

A retirement plan doesn't qualify for tax-preferential treatment unless it meets the eligibility and participation standards. These general rules are:

  • A plan may not require an employee to be older than 21 to participate, and
  • Two ways to credit service to an employee:
    • Hours of service: A 401(k) plan may not require more than a year of service as a condition of being eligible to participate.
        • A year of service means a calendar year, plan year or any other consecutive 12-month period during which the employee completes at least 1,000 hours of service starting on the employment commencement date.
    • Elapsed time: Under the elapsed time method, an employee’s eligibility to participate isn’t based on the completion of a specified number of hours of service, but it’s generally determined in reference to a 12-month period.
  • An eligible employee must enter the plan within 6 months after satisfying the eligibility requirements under the plan.
  • The plan document may be more liberal by allowing a younger age and lesser service requirement. For example, a plan may allow a person to participate immediately when hired.
  • Your plan document contains the definitions and requirements for becoming a plan participant.

In addition, you must give eligible employees the opportunity to make a salary deferral election and should retain copies of who is notified of this opportunity and when.

How to find the mistake:

Review your plan document concerning eligibility and participation. Check when employees are entering the plan.

  • Make a list of all employees who received a W-2.
  • Compare each employee's date of hire, birth, termination and number of hours worked against the eligibility and participation requirements of the plan document.
  • Determine the date that each employee is entitled to become a plan participant (plan entry date) according to the plan document.
  • Inspect payroll and plan records to ensure that the employees timely entered the plan and that you gave them the opportunity to make a deferral election.

How to fix the mistake:

Corrective action:
Generally, if you didn't give an employee the opportunity to make elective deferrals to a 401(k) plan, you must make a qualified nonelective contribution to the plan for the employee. This contribution must compensate for the missed deferral opportunity. The corrective QNEC is an employer contribution that's intended to replace the lost opportunity to a participant who wasn't permitted to make elective deferrals.The QNEC must be 100% vested and subject to the same distribution restrictions as elective deferrals. Forfeitures can’t be used for QNECs.

The amount of the QNEC is equal to 50% of the employee’s missed deferral determined by multiplying the actual deferral percentage for the employee’s group (HCE or NHCE) in the plan for the year of exclusion by the employee’s compensation for that year.

In situations where the exclusion lasts more than three months but is discovered before the end of the second plan year after the year of the failure and certain conditions are met, the corrective contribution for the employee’s missed deferral can be reduced to 25%, adjusted for any lost earnings through the date of correction. The QNEC is reduced to 25% (instead of 50%) if the following conditions are met:

  • Timing--Correct deferrals begin no later than the earlier of: (1) the first payment of compensation made on or after the last day of the second plan year following the plan year in which the failure occurred; or (2) if the plan sponsor was notified of the failure by the affected eligible employee, the first payment of compensation made on or after the last day of the month after the month of notification.
  • Notice--Notice is provided that meets all content requirements to the affected eligible employee not later than 45 days after the date on which correct deferrals begin.
  • Corrective Contributions--Corrective contributions (including the 25% QNEC and employer contributions to make up for any missed matching contributions) are made by the last day of the second plan year following the year the failure occurred, and adjusted for earnings.

Example:
Employer D sponsors a 401(k) plan with eight participants. The plan uses a calendar plan year. The plan has a one-year-of-service-eligibility requirement and provides for January 1 and July 1 entry dates. Jack, whom Employer D should’ve allowed to make elective deferrals on January 1, 2013, wasn’t given that opportunity until January 1, 2014. Jack was a NHCE with compensation for 2013 of $80,000. The ADP for 2013 was 10% for HCEs and 8% for NHCEs. Employer D found this mistake during a plan review in 2014.

Employer D must make a corrective contribution for the 2013 missed deferral opportunity. Jack’s missed deferral is equal to the 8% ADP for NHCEs multiplied by $80,000 (compensation earned for the portion of the year in which D erroneously excluded Jack, January 1 through December 31, 2013). The missed deferral amount, based on this calculation is $6,400 ($80,000 x 8%). The missed deferral opportunity is $3,200 (50% multiplied by the missed deferral of $6,400). Employer D must make a corrective contribution of $3,200, adjusted for earnings through the date of correction, for Jack.

Correction programs available:

Self-Correction Program:
The example shows an operational problem because Employer D failed to follow the plan terms by not giving Jack the opportunity to participant in the plan for the 2013-plan year. If the other eligibility requirements of SCP are satisfied, Employer D may use SCP to correct the failure.

  • No fees for self-correction.
  • Practices and procedures must be in place.
  • If the mistakes are significant in the aggregate:
    • Employer D needs to make a corrective contribution by December 31, 2015.  If the corrective contribution is made on or before that date and other conditions are met, Employer D may also qualify for reducing the QNEC to 25% of the missed deferral.
    • If not corrected by December 31, 2015, Employer D isn't eligible for SCP and must correct under VCP.
  • If the mistakes are insignificant in the aggregate, Employer D can correct beyond the two-year correction period for significant errors. Whether a mistake is insignificant depends on all facts and circumstances.

Voluntary Correction Program:
Correction is the same as under “Corrective action.” Employer D makes a VCP submission according to Revenue Procedure 2013-12. The fee for the VCP submission is $750. When making a VCP submission, D should include Forms 8950 and 8951 and consider using Form 14568, Appendix C – Part 1– Model VCP Compliance Statement.

Audit Closing Agreement Program:
Under Audit CAP, correction is the same as under "Corrective action." Employer D and the IRS enter into a closing agreement outlining the corrective action and negotiate a sanction based on the maximum payment amount.

How to avoid the mistake:

  • Review your plan document for the definition of “employee” and provisions of employee eligibility.
  • Provide proper training about the plan document to in-house personnel who determine employee eligibility.
  • Look at your payroll records for the total number of employees, birth dates, hire dates, hours worked, and other pertinent information. Also inspect Form(s) W-2 and state unemployment tax returns and compare employee data on these records with the payroll records to see if employee counts are accurate.
  • Establish protocols and a corrective action plan that will be triggered when errors are identified.

401(k) Plan Fix-It Guide
401(k) Plan Overview
EPCRS Overview
401(k) Plan Fix-It Guide (pdf)
401(k) Plan Checklist
Additional Resources

IRS.gov / Retirement Plans / Correcting Plan Errors / Fix-It Guides / Potential Mistake
 

Page Last Reviewed or Updated: 23-Aug-2016