Fixing Common Plan Mistakes - Failure to Limit Contributions for a Participant

 

Background:

Qualified defined contribution retirement plans – such as pension, profit-sharing and 401(k) plans - and IRA-based Simplified Employee Pension (SEP) plans must limit contributions and forfeitures allocated to a participant’s account.

Internal Revenue Code Section 415(c) provides that during a limitation year, the annual additions (total of employer contributions, employee contributions and forfeitures allocated to a participant) cannot exceed the lesser of 100% of the participants compensation or:

  • $61,000 in 2022
  • $58,000 in 2021
  • $57,000 in 2020
  • $56,000 in 2019

Annual Additions:

Each participant’s annual additions include the following types of contributions:

  • Elective salary deferrals, including pre-tax, after -tax and Roth contributions made to qualified plans, and salary reduction contributions made to SEP plans,
  • Employer profit-sharing contributions
  • Forfeitures allocated
  • After-tax employee contributions
  • Employer matching contributions

Annual additions generally do not include:

  • Catch-up contributions (IRC 414(v))
  • Rollover contributions
  • Loan repayments (unless using above-market interest rates)

Finding the Mistake:

To verify that your plan does not have annual additions above the 415(c) limit, the plan administrator should timely prepare a 415(c) allocation schedule for each plan participant. If you have a service provider that assists you in the operation of your plan, you may want to check with them to determine if a 415(c) schedule is one of the services they provide to your plan. A 415(c) schedule would include:

  • 415 compensation. Find the definition in your plan document
  • Limitation year: If the plan does not define the limitation year, it is deemed to use the calendar year. A different 12-month period, such as the plan year, may be defined in the plan.
  • 415(c) annual additions limit. The lesser of 100% of compensation or the annual dollar amount specified above.
  • Total 415(c) annual additions: Total of the above types of contributions allocated to each participant under each defined contribution plan you sponsor.
  • Excess Annual Additions: The annual additions that are in excess of the 415(c)  limit

Fixing the Mistake:

If you determine that participants in your plan have annual additions (contributions) that exceed the 415(c) limit, you can correct this mistake using one of the IRS correction programs described in Rev. Proc. 2021-30PDF. Sections 6.06 outlines special rules for correcting excess annual additions. Most plan mistakes can be corrected using the Self-Correction Program (SCP).

For a participant with both employer contributions and employee elective salary deferral contributions that has annual additions that exceed IRC Section 415(c), correction includes:

Step 1: Distribute unmatched elective salary deferral contributions (adjusted for earnings) to the affected participant. If any excess remains, proceed to Step 2.

Step 2: Distribute elective salary deferral contributions (adjusted for earnings) that are matched, and forfeit related employer matching contributions (adjusted for earnings). If any excess remains, proceed to Step 3.

Step 3: Forfeit employer profit-sharing contributions until the annual additions longer exceed the 415(c) limits.

The employer should report the corrective distribution made to the participant on Form 1099-R. The participant should include the distribution as income but does not have to pay the 10% additional tax on early distributions under IRC Section 72(t). The participant may not rollover the corrective distribution to another qualified plan or to an IRA.

The plan sponsor should transfer the forfeited employer contributions (profit-sharing or matching) to an unallocated plan account. These amounts are used to reduce employer contributions in subsequent years.

Example:

In 2020, John earned $100,000 in compensation as an employee of the QP Corporation and was a participant in QP Corporation’s 401(k) Plan. At the end of 2020, John is age 48. The plan permits elective contributions and provides a 100% matching employer contribution of the first $11,000 of an employee’s elective salary deferral contribution, as well as discretionary profit-sharing contributions. The plan does not allow an employee to designate any portion of their elective contribution as a Roth contribution. QP Corp did not allocate any forfeitures to participants in 2020. During 2020, John had the following contributions to his account:

  • elective salary deferral contributions: $19,000
  • employer matching contributions: $11,000
  • employer profit-sharing contributions: $38,000

John’s $19,000 deferral is less than the $19,500 deferral limit for 2020.

John’s 415(c) contribution limit for 2020 is $57,000 (the lesser of $57,000 or 100% of John’s $100,000 compensation). John’s annual addition of $68,000 (19,000 + 11,000 + 38,000) for 2020 exceeded the 415(c) limit of $57,000 by $13,000.

QP discovered the failure to limit the contributions for John in 2021.

Applying these steps, the correction of the excess contribution of $13,000 for John would be as follows:

Step 1: John made $8,000 in unmatched elective contributions (elective salary deferral of $19,000 less the $11,000 QP Corp matching contributions).

The plan must distribute the $8,000 (adjusted for earnings) to John. After the distribution, the remaining $5,000 excess is corrected under Step 2.

Step 2: John has $11,000 of elective salary deferrals that were matched, and $11,000 of matching contributions left. The plan must distribute $2,500 in elective salary deferrals (adjusted for earnings) and forfeit the corresponding matching contribution of $2,500 (adjusted for earnings) back to the plan. This step fully corrects John’s remaining $5,000 excess.

As a result, John will receive a total distribution of $10,500 ($8,000 + $2,500, adjusted for earnings). John includes the entire $10,500 (adjusted for earnings) corrective distribution in his income for 2021. John will not owe the additional 10% tax on early distributions under IRC Section 72(t). The distribution is not eligible for rollover to another qualified plan or an IRA.

In addition, the plan will forfeit $2,500 (adjusted for earnings) from John’s matching contribution account to an unallocated plan account and used to reduce employer contributions for current and subsequent years.

Correction Programs Available:

The IRS Employee Plans Compliance Resolution System (EPCRS) permits any size business or organization that sponsors a retirement plan (including SEP and SIMPLE IRA plans) to identify and correct most plan failures. The two EPCRS programs available for plans that want to voluntary correct failures to limit contributions to participants are:

  • Self-Correction Program (SCP) – Correct certain plan failures without contacting the IRS or paying a user fee. You can self-correct most plan mistakes without ever contacting the IRS. Significant mistakes can be self-corrected by the end of the 3rd year following the year the mistake occurred, insignificant mistakes at any time.
  • Voluntary Correction Program (VCP) – Correction of failures not eligible for SCP or to get the IRS’s written agreement that specified failures were properly corrected.

QP Corp may correct this mistake using SCP. Even if QP Corp determined this mistake was significant, they’re still within the three-year limit to correct significant mistakes. For more information about EPCRS, check EPCRS Overview.

Avoiding the Mistake:

The employer should monitor employees’ elective contributions made during the limitation year. After determining the corresponding matching contribution under the terms of the plan, the employer should consider the IRC Section 415 limitations while determining:

  1. the amount of discretionary profit-sharing contribution, and
  2. where appropriate, how profit-sharing contributions could be allocated among plan years.