An employer’s failure to execute an employee’s election to defer amounts to a 401(k) plan is a relatively common error. Like its cousin – mistakenly excluding an employee from a plan – the problem can be rectified by making a qualified nonelective contribution (QNEC) to the plan on behalf of the employee, and as in the case of other operational problems, the error can be fixed through the Employee Plans Compliance Resolution System (EPCRS).
The problem to address is one of a missed deferral opportunity: the employee received taxable compensation instead of being able to defer amounts on a pre-tax basis and to accumulate earnings on those deferred amounts tax free until qualified distributions are taken. Let’s look at two examples, neither of which entails “catch-up” contributions for employees age 50 or older, after-tax contributions, or “designated Roth” contributions. In both cases, the employees are nonhighly compensated employees (NHCEs).
Situation 1: Amy’s elective deferral election at the start of 2016 somehow was never processed by the employer’s payroll system. As a result, Amy received taxable compensation amounts that should have been contributed to the plan during the first six months of the year. The facts in this situation include: the plan’s actual deferral percentage (ADP) for NHCEs of 5%; Amy’s election form agreeing to a deferral of 10% of pay; and her compensation of $20,000 for the six months that no deferrals were made.
Situation 2: Bob elected to defer 5% of his compensation in 2016. The plan includes bonuses in the definition of compensation that is used for an employee making elective contributions. Although Bob was able to make deferrals on his base compensation, the payroll system overlooked his bonus. The facts here entail an ADP of 3%; Bob’s base compensation of $19,000; and his bonus of $2,000.
As in the case of an erroneous exclusion of an employee from the plan, the remedy requires the employer to make a corrective contribution of 50% of the missed deferral (adjusted for earnings) on behalf of the affected employee. The employee is fully vested in those contributions, which are subject to the same withdrawal restrictions that apply to elective deferrals. However, unlike in the case of mistaken exclusions where the missed deferral amount is estimated based on the ADP for the employee category (e.g., NHCE), in both illustrative examples, the employees’ election deferral amount is known. Thus, the missed deferral and the corresponding corrective contribution (50% of the missed deferral) are based on the participant’s actual election instead of the ADP (i.e., 5% or 3%, respectively) of the NHCEs.
Before correcting for the exclusion, however, the plan must evaluate whether, in the event that the employee had made the missed deferral, it would still pass the applicable ADP test. The ADP test should be corrected according to the plan’s terms before implementing any corrective contribution on behalf of the employee. In addition, the missed deferral amount should be reduced, if necessary, to ensure that the employee’s elective deferrals (the sum of deferrals actually made and the missed deferrals, for which a corrective contribution may be required) comply with all other applicable plan and legal limits. Assuming that the plan passes the ADP test and that no changes must be made to the missed deferral amounts on account of plan or legal limits, the fixes for Situations 1 and 2 are determined as follows:
Situation 1: Amy’s missed deferral amount is $2,000 (i.e., 10% (Amy’s election percentage) multiplied by $20,000 (her compensation earned during the period in which the employer failed to implement her election)). The amount of the corrective contribution the employer must make on Amy’s behalf is $1,000 (i.e., 50% multiplied by Amy’s $2,000 missed deferral amount).
Situation 2: Bob’s missed deferral amount is $100 (i.e., 5% (Bob’s election percentage) multiplied by $2,000 (his 2006 bonus from which elective contributions were not made even though he elected to make a contribution of 5% of all compensation, which included bonuses)). The corrective contribution required on behalf of Bob is $50 (i.e., 50% multiplied by his $100 missed deferral).
The described correction only applies to missed deferrals. The corrective contribution also must be adjusted for earnings from the date that the elective deferrals should have been made through the date of the corrective contribution. Depending on how soon this failure is identified and corrected other IRS approved correction methodologies may result in lesser corrective contributions for the missed deferrals. Refer to Appendix A.05(8) and Appendix .05(9) of Rev. Proc. 2019-19 (PDF) for details.
Making Sure It Doesn’t Happen Again
Employers should establish systems that can help ensure that employees are provided the opportunity to make deferrals/after-tax contributions to the plan according to the plan’s terms. They also should work to ensure that third-party plan administrators have sufficient understanding of the plan’s terms to operate the plan accordingly. This is especially important if there have been plan amendments or changes to either payroll systems or administrators.
Keep in mind that despite all of your good efforts, mistakes happen. In that case, the IRS can help you correct the problem so that you retain the benefits of your qualified plan.