How to Correct a Frequent Error: Not Withholding the Proper Amount of 401(k) Deferrals
Administering a 401(k) plan can be complicated and challenging, creating the opportunity for errors to occur. One of the most frequent errors encountered is not withholding the proper amount of 401(k) deferrals based on the Plan provisions and an employee’s election.
Oftentimes, an employee makes their deferral election based on a percentage of eligible wages that are defined in the Plan document. Plan documents typically define compensation as total compensation or taxable compensation; therefore, they may exclude certain types of payroll codes and have varied definitions of compensation for different purposes. In most situations, employers may not have set the correct pay codes in the payroll system to match the Plan provisions—resulting in failure to properly withhold in accordance with the employee’s election. These errors most commonly occur in special payroll codes such as bonuses, commissions, final paychecks or other unique one-time payment codes.
Addressing The Error
Failure to withhold according to the employee’s election can generally be corrected under the IRS Self Correction Program. The IRS program states that in the event too much 401(k) was withheld, participants should be refunded the excess contribution. However, if the employer under-withheld from the employee’s election, then the employer may be required to make a corrective contribution under the missed deferral opportunity rules.
The missed deferral opportunity rules generally require the employer to make a qualified nonelective contribution (QNEC) to the impacted employee. The corrective QNEC is intended to replace the lost opportunity to a participant that:
- Wasn’t permitted to make an elective contribution
- Or whose election was not made in accordance with their election because the proper Plan definition of compensation was not followed
Generally, the amount of the QNEC is equal to 50% of the employee’s missed deferral opportunity, meaning 50% of the amount they should have contributed to the Plan. If the employee should have also received an additional matching amount, that contribution must be corrected at 100% of the amount the employee would have received.
If errors are found and fixed promptly, Plan sponsors may reduce the QNEC from 50% to 25% if the following conditions are met:
- The impacted employee must still be employed at the time of correction
- The period of failure exceeds three months but no more than two years after the end of the Plan year the error occurred (if the period of failure is less than three months, no corrected QNEC is required)
No QNEC is required for auto-enrollment or auto-escalation errors if the error is corrected within 9 ½ months of the end of the plan year in which the error occurred (or, if earlier, the date on which the employee notifies the Plan sponsor of the error). This provision is scheduled to expire on December 31, 2023.
Correct deferrals must begin 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 impacted 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 commencement of auto-enrollment contributions), the affected participant must receive a special notice as outlined in Rev Proc 2021-30. If the participant terminates employment before the notice is provided, then this requirement has not been met.
Plan sponsors should review the proper correction process with their Plan consultant, communicate resolution with Plan participants and fund corrective contributions as required. Plan controls should be evaluated to ensure subsequent issues do not reoccur.
The SECURE 2.0 Act, enacted December 29, 2022, includes new retirement plan self-correction guidance to streamline procedures. One provision made the temporary safe harbor for correction of automatic deferral failures permanent (it was set to expire on December 31, 2023). Please note that plan correction guidelines are usually addressed by the IRS through its Employee Plans Compliance Resolution (EPCRS), and it is anticipated that EPCRS will be updated within the next two years to reflect the guidance on self-correction for eligible errors. More details on the IRS correction process can be located in the guide at: https://www.irs.gov/retirement-plans/401k-plan-fix-it-guide.
Employers can recognize significant cost savings by reviewing employee salary deferral elections and pay code set ups regularly. We recommend employers routinely review the set up in their payroll system and compare it to their current Plan document definition of compensation. Please contact our employee benefits team to talk about how this affects you: