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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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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 qualified nonelective contribution (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.

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.

Other IRS safe harbor correction methods may be acceptable to fix this mistake. For failures found and fixed promptly, plan sponsors have the option to reduce the corrective QNEC contribution for the lost opportunity cost from 50% of the missed deferral to 25% under the following conditions:

  • The excluded employee must be currently employed by the employer at the time of correction
  • The period of failure exceeds three months
  • Correct deferrals finally begin by the first payment of compensation made on or after the earlier of:
    • The last day of the second plan year after the plan year in which the failure first began for the affected employee, or the last day of the month after the month the affected eligible employee first notified the plan sponsor; and
    • Within 45 days of being given the opportunity to make salary reduction contributions (or the commencement of auto-enrollment contributions), the affected participant must receive a special notice. See Appendix A.05(9) discussed in Rev. Proc. 2016-51 for details as to the specific content that must be in this notice. If the participant terminates employment before the notice is provided, then this requirement has not been met.

If the period of failure is less than three months, no corrective QNEC for the missed deferral opportunity is required. The excluded employee must begin to participate and if the plan provided for auto-enrollment, the commencement of deferrals occurs within the three-month period beginning from the start of the failure and the issuance of the special notice occurs within the 45-day timeframe.

All other corrective contributions must be paid to the 401(k) plan before the end of the  second plan year beginning after the initial year of the failure.

For 401(k) plans with automatic contribution features (i.e., auto-enrollment and auto-escalation), the corrective QNEC contribution for the missed deferral opportunity is reduced to zero if correct deferrals begin by the first payment of compensation made on or after the earlier of:

  • 9½ months after the end of the plan year in which the failure first occurred, or
  • the last day of the month after the month the affected employee first notified the plan sponsor of the error.

The special notice to the affected employee must be provided within the applicable 45-day timeframe.  See Appendix A.05(8) discussed in Rev. Proc. 2016-51 for additional details. This special 0% rule only applies to failures occurring before 2021. The plan sponsor is still responsible for providing correcting matching contributions or missed employer contributions to the 401(k) plan within the two-year timeframe used to correct significant operational failures under Revenue Procedure 2016-51.

Alternatively, the chart below outlines the safe harbor situations in which a zero or a reduced corrective QNEC for missed deferral apply:

  Correction of elective deferral failures for plans with automatic enrollment feature (i.e., failure to implement automatic enrollment feature and/or failure to implement an affirmative election for a participant who would otherwise be subject to the automatic enrollment feature) Correction of exclusion of employees for plans without automatic enrollment feature Correction of exclusion of employees for all 401(k) plans with or without automatic enrollment feature
Required contribution for missed deferral opportunity None if conditions below are satisfied. None if conditions below are satisfied. 25% of missed deferral- if conditions below are satisfied.
Commencement of Correct Deferrals (i.e., correct withholding and deposit from compensation going forward)

Earlier of payment of first compensation that begins on or after:

  • 9½ months after plan year in which failure occurred, or
  • Last day of the month following the month in which employee notified employer of the failure.

Earlier of payment of first compensation that begins on or before:

  • 3 months after the failure occurred, or
  • Last day of the month following the month in which employee notified employer of the failure.

Earlier of payment of first compensation that begins on or after:

  • the end of the second plan year following the plan year in which failure occurred, or
  • Last day of the month following the month in which employee notified employer of the failure.

Notice providing:

  • information on failure,
  • corrective contribution,
  • commencement of correct deferrals,
  • the opportunity to increase deferrals going forward, and
  • plan contact information.
Notice must be provided within 45 days of the commencement of correct deferrals. Notice must be provided within 45 days of the commencement of correct deferrals. Notice must be provided within 45 days of the commencement of correct deferrals.

Corrective contributions.

Details for determining SCP correction period, referred to in the columns can be found in Section 9.02 of Rev. Proc. 2016-51

Corrective matching contributions (including earnings) must be made by the end of the SCP correction period for significant failures. In most cases, that is the end of the second plan year after the plan year in which mistake occurred. (Note- exceptions exist. E.g., SCP correction period may end if plan is under IRS audit) Corrective matching contributions (including earnings) must be made by the end of the SCP correction period for significant failures. In most cases, that is the end of the second plan year after the plan year in which mistake occurred. (Note- exceptions exist. E.g., SCP correction period may end if plan is under IRS audit) Corrective matching contributions and 25% of missed deferrals (both adjusted for earnings) must be made by the end of the SCP correction period for significant failures. In most cases, that is the end of the second plan year after the plan year in which mistake occurred. (Exceptions possible, e.g., SCP correction period may end if plan is under IRS audit)

Example 1:
Employer D sponsors a 401(k) plan with eight participants and plan assets of $275,000. 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, 2014, wasn’t given that opportunity until January 1, 2015. Jack was a NHCE with compensation for 2014 of $80,000. The Actual Deferral Percentage (ADP) for 2014 was 10% for highly compensated employees (HCEs) and 8% for nonhighly compensated employees (NHCEs). Employer D found this mistake during a plan review in 2015.

Employer D must make a corrective contribution for the 2014 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, 2014). The missed deferral amount, based on this calculation is $6,400 ($80,000 x 8%). The corrective contribution for 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.

Example 2:
Corporation XYZ maintains a calendar year a 401(k) plan that contains automatic contribution features. In this case, all employees in the 401(k) plan automatically have salary reduction contributions of 3% of compensation withheld from their pay. Participants may decrease or increase this amount by filing an affirmative, written election. In 2016, XYZ realized four employees hired in June of 2015, were improperly excluded from the plan due to an administrative error. XYZ discovered the failure in 2016 and auto-enrolled the employees in the 401(k) plan as of April 1, 2016, and began withholding 3% of their compensation as salary reduction contributions to the plan. On May 1, 2016, XYZ issued a special notice to employee that satisfied the content requirement specified in Rev. Proc. 2016-51, Appendix .05(8). XYZ does not have to provide a corrective contribution for the missed opportunity to make salary reduction contributions due to the employees’ improper exclusion from the plan in 2015 and first three months of 2016. The conditions of the Appendix .05(8) safe-harbor were met when:

  • Improperly excluded employees were enrolled; special notice provided within the applicable 45 day period; and
  • The above actions occurred within 9 ½ months after end of the plan year which the failure first occurred (i.e., before October 15, 2016); and
  • XYZ is still responsible to pay corrective contributions to the 401(k) for any 2015 or 2016 matching contributions or employer contributions, if applicable, that the employees would have been entitled to under the terms of the 401(k).

Example 3:
Assume the same set of facts, except that the terms of XYZ’s 401(k) plan did not provide for automatic contribution features. Assume the excluded employees become plan participants on April 1, 2016, and at that time were given the opportunity to participate in the 401(k) plan. XYZ issued the special notice on May 1, 2016. Under these facts, the lost opportunity cost for the missed deferrals would be 25% of the missed deferral amount for 2015 and first three months of 2016. Adjust this amount for earnings through the date of correction. This is permitted because XYZ complied with the special safe harbor requirements in the Appendix A.05(9) safe harbor discussed in Rev. Proc. 2016-51. XYZ would still owe 100% of any owed corrective contributions associated with matching or non-elective employer contributions, if applicable, and all corrective contributions would have to be paid to the plan before the end of the second plan year beginning after the initial year of the failure.

Example 4:
Assume the same set of facts, except that one of the XYZ’s excluded employees terminated in March of 2016. Then none of the special safe harbors in Appendix A.05(8) or .05(9) would be applicable to the terminated employee as the conditions discussed in Rev. Proc.  2016-51 can’t be met as the employee is no longer employed by XYZ at the time of correction. Therefore, the lost opportunity cost for the missed deferrals would be 50% of the missed deferral amounts for this employee. Adjust for earnings through the date of correction.

The concepts relating to a reduced QNEC for missed deferrals may also be applied to failures involving a failure to implement a 401(k) plan’s automatic enrollment/escalation features or a failure to properly implement a participant’s written salary reduction election.

Correction programs available:

Self-Correction Program:
Example 1 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 2014-plan year. If the other eligibility requirements of SCP are satisfied, Employer D may use SCP to correct the failure.

  • No IRS imposed user 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, 2016.
    • If not corrected by December 31, 2016, 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:
For Example 1, correction is the same as under “Corrective action.” If not under audit, Employer D makes a VCP submission according to Revenue Procedure 2016-51. When making the submission, D must include Forms 8950 and 8951 and consider using the model documents set forth in the Form 14568 series. Based on the amount of plan assets in Example one, $275,000, Employer D would pay a user fee of $1,500 for a submission made in 2018. If a plan’s assets exceed $500,000, the user fee would be higher. VCP user fees may change in subsequent years.

Audit Closing Agreement Program:
Under Audit CAP, correction is the same as under SCP or VCP. Employer D and the IRS enter into a closing agreement outlining the corrective action and negotiate a sanction. The sanction under Audit CAP is based on facts and circumstances, as discussed in Section 14 of Revenue Procedure 2016-51.

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 Checklist
Additional Resources

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