401(k) Plan Fix-It Guide - You didn't use the plan definition of compensation correctly for all deferrals and allocations.
Find the Mistake
Fix the Mistake
Avoid the Mistake
|3) You didn't use the plan definition of compensation correctly for all deferrals and allocations.
||Review the plan document definition of compensation used for determining elective deferrals, employer nonelective and matching contributions, maximum annual additions and top-heavy minimum contributions. Review the plan election forms to determine if they're consistent with plan terms.||Corrective contribution or distribution.||Perform annual reviews of compensation definitions and ensure that the person in charge of determining compensation is properly trained to understand the plan document.|
Because your plan may use different definitions of compensation for different purposes, it’s important to apply the proper definition for deferrals, allocations and testing. A plan’s compensation definition must satisfy rules for determining the amount of contributions. One of those rules is that the amount of compensation considered under the plan can’t exceed $260,000 in 2014 (subject to cost-of-living adjustments for later years). This limit is described in IRC Section 401(a)(17).
You must follow the plan document compensation definitions. Compensation generally includes the pay a participant received from the employer for personal services for a year including:
- Wages and salaries
- Fees for professional services
- Other amounts received (cash or non-cash) for personal services actually rendered by an employee, including, but not limited to:
- Commissions and tips
- Fringe benefits
Your plan may contain different compensation definitions for different purposes. In some cases, you or the plan administrator may use an incorrect definition in determining the compensation eligible to be deferred, computing the matching contribution or in calculating the ADP or ACP test. Also, you may fail to limit compensation as required by IRC Section 401(a)(17).
How to find the mistake:
Review the plan document to determine if you're using the proper compensation for allocations, deferrals and testing. Many plan sponsors operate their plan based on a plan summary of the definitions and operational requirements. As the plan is amended, the compensation definition may change while the plan continues to operate as it had previously.
Review the plan sections dealing with allocations and deferrals. Each plan contains sections, either in the plan document or in an adoption agreement, that discuss how the plan must make allocations and deferrals. This section may say, for example, “Employees may defer up to 15% of their Compensation…” You then have to go to the plan section containing definitions and find the “Compensation” definition. Spot-check deferrals and allocations to see if you're using the correct compensation. Some of these definitions can get complicated with expense reimbursements, car allowances, bonuses, commissions and overtime pay that is or is not included in the definition of compensation. If you have a plan with a complicated definition of compensation, you may want to develop a worksheet to calculate the correct amounts.
How to fix the mistake:
There are a couple of ways to make corrections when you have improperly allocated amounts because you didn’t follow the plan definition of compensation. If you've improperly determined elective deferrals, give the participant a distribution of the excess amount plus earnings. If there are improper profit-sharing allocations, forfeit and reallocate the allocations plus earnings to plan participants or put them in an unallocated account for later use. Of course, an improper allocation may also result in an under contribution. If this happens, make a corrective contribution, including earnings, for the affected participants.
Employer Z sponsors a 401(k) plan with six participants. The plan definition of compensation for deferrals and allocations was amended, effective 2005, to exclude bonuses. For the 2012-plan year, Employer Z improperly included bonuses in compensation when determining allocations and deferrals. Three highly compensated employees each had base compensation of $120,000 and a $30,000 bonus. Each of these highly compensated employees had deferral percentages of 6% of compensation and the plan provides for a fixed profit-sharing allocation of 5% of compensation to each participant’s account.
- 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).
- 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).
For each employee, Employer Z should forfeit the profit-sharing allocations of $1,500 plus earnings and put the funds in an unallocated account to use for profit-sharing allocations in future years and distribute the improperly allocated elective deferrals of $1,800 plus earnings to each of the three employees.
Correction programs available:
The example illustrates an operational problem because Employer Z didn't follow the plan terms by including bonuses in compensation when determining plan allocations. If the other eligibility requirements are satisfied, Employer Z may use SCP to correct the mistake.
- No fees for self-correction.
- Practices and procedures must be in place.
- If the mistakes are significant in the aggregate:
- Employer Z needs to complete correction by December 31, 2014.
- If not corrected by December 31, 2014, Employer Z isn't eligible for SCP and must correct under VCP.
- If the mistakes are insignificant in the aggregate, Employer Z 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 described under SCP. Employer Z makes a VCP submission. Employer Z's plan had six participants, so the fee for the VCP submission is $750. When making the submission, Z should include Forms 8950 and 8951 and consider using the model documents in Revenue Procedure 2013-12 Appendix C.
Audit Closing Agreement Program:
Under Audit CAP, correction is the same as under SCP. Employer Z 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:
- Perform annual reviews of the plan operations.
- If the plan document is amended, check the definitions against the old document, noting any differences. Have a centralized person or department responsible for maintaining all plan documents.
- If you amend your plan document, communicate those changes to everyone involved in the plan’s operation. Plan sponsors should develop an internal communication mechanism to timely and accurately advise plan administrators and outside service providers (outside plan consultant, actuary and/or third party administrator/record keeper) of changes.
- Provide proper training of in-house personnel who determine compensation to understand the plan document.
- Know what your third party administrators have agreed to provide. They may be relying on you for information, such as compensation and deferral amounts used in their work. Retain a copy of your third party administrator service contract including any updated contracts; and keep a summary of what’s being supplied to the plan by the third party administrator, actuary or consultant. Keep this service contract and summary with the person responsible for maintaining all plan documents.
- Try to simplify your plan’s definition of compensation and use the same definition for multiple purposes.