The new change provides penalty relief for plans that commit an elective or automatic deferral failure. A deferral failure occurs when a plan sponsor fails to correctly implement an automatic deferral contribution per the plan’s framework, fails to implement an elective deferral – when participants “elect” to make contributions, and also if a plan sponsor fails to provide an employee with the opportunity to make an affirmative election because of improper exclusion. Prior to the changes introduced, the “missed deferral opportunity” cost the employer was required to pay was generally 50% of the missed deferral unless there were at least nine months of the plan year remaining after deferrals started. The cost could vary based on the type of failure:
- When a participant was improperly excluded, the cost was 50% of the missed deferral based on the average of the deferral percentage for the group the participant was in (highly compensated or non-highly compensated employees).
- For safe harbor 401(k) plans, the cost was 50% of a 3% deferral. For a safe harbor plan with an enhanced match, the missed deferral was 50% of the percentage that receives a dollar-for-dollar match.
- When a participant filed a salary deferral election that was not implemented, the correction was 50% of the amount the participant elected.
- When an eligible participant failed to be automatically enrolled, the cost was 50% of the deferral that should have occurred.
If the plan called for matching contributions, the employer also contributed an amount equal to the total matching contribution the participant would have received had his or her deferrals been handled correctly.
Employers protested that deferral correction rules overcompensated participants when failures lasted for short periods, and the high costs of correcting deferral failures in automatic contribution arrangements were discouraging them from adopting such features. They also noted that deferral failures occur more frequently in plans with automatic contribution and escalation features. Based on this feedback, the IRS issued three updated rules:
Automatic Contribution Failures:
There is no longer a missed deferral opportunity cost for automatic enrollment or automatic increase (escalation) failures that are found and corrected by the first payroll date after the earlier of:
- Nine and a half months after the end of the plan year in which the automatic contribution or increase should have occurred
- The last day of the month following the month in which the participant advises the sponsor of the problem
Elective Deferrals Failures Caught Within Three Months:
In order to encourage the early correction of elective deferral failures, a new safe harbor has been established for elective deferral failures that are discovered within three months. Under this new safe harbor, no corrective contribution for the missed elective deferrals is required, provided deferrals are restarted by the first payroll date after the earlier of:
- Three months after the missed deferrals occurred
- The last day of the month following the month in which the individual advises the sponsor of the problem
Elective deferral failures often arise as a result of a single missed payroll for an eligible employee, so this safe harbor will be applicable to many failures and much easier to correct.
Elective Deferral Failures Beyond Three Months:
When elective deferral failures extend beyond three months, but do not extend beyond the end of the second plan year after the failure occurred, a safe harbor correction method has been established that permits the employer to make a corrective contribution equal to 25% of the missed deferrals (instead of the previous 50%).
It’s important to note that under all these new correction methods, the employer must also:
- Make a matching contribution in the amount the participant would have received had the deferrals been handled correctly in the first place
- Provide a notice to the affected participant within 45 days of the date the proper deferrals start occurring
- Calculate and contribute lost earnings for any corrective contributions the employer is required to make
These new guidelines will apply for any 401(k) and 403(b) deferral failures that occur between April 2, 2015 and December 31, 2020. The IRS will then decide whether they will extend the automatic deferral failure rule based on several factors. If you’d like to learn more about 401(k) or 403(b) deferrals, elective and automatic deferral plans, or the changes in missed deferral opportunity penalties, contact Sikich today!