The Internal Revenue Service has identified several common mistakes made when administering a voluntarily established pension plan. We have summarized some of the rules and regulations that impact plan operations and administration below.
Most Common Mistakes
1. The plan failed the annual ADP and ACP nondiscrimination tests. Traditional 401(k) plans must be tested each year to ensure that the amount of contributions made for nonhighly compensated employees are not proportionally lower than contributions made for highly compensated employees. If the test fails, corrective action is required in order to keep the plan qualified.
Correction methods include:
– Make a qualified nonelective contribution for nonhighly compensated employees to the extent needed to pass the testing. A qualified nonelective contribution is always considered 100% vested. The plan provisions must provide for this type of contribution in order for it to be available as a method of correction.
– Refund excess contributions, including earnings, to the highly compensated employees.
To potentially avoid failure of the annual ADP and ACP testing, plan sponsors can consider utilizing a safe harbor contribution or automatic enrollment feature.
2. Participant loans do not conform to the requirements of the plan document. Before allowing participants to borrow money from the plan, sponsors should ensure that the plan document allows loans. Some plan documents include a complete description of the loan rules, while other plan documents provide a statement that the plan allows loans subject to separate written loan program rules.
A loan must meet a number of rules to prevent it from being treated as a taxable distribution.
These rules include:
– The loan must be an enforceable agreement.
– The loan cannot exceed 50% of the participant’s vested account balance up to a maximum of $50,000.
– The participant must be required to make level amortized payments at least quarterly (under most circumstances).
3. Hardship distributions were not made properly. A hardship distribution may be allowed under a 401(k) plan because of an immediate and heavy financial need. These distributions generally are limited to the amount of elective deferrals and do not include any income earned on the deferred amounts. (The employer may permit hardship withdrawals on profit sharing contributions if they wish.) If the distribution is in excess of the amount needed to relieve the employee’s immediate financial need or if the financial need may be satisfied from other resources available to the employee (including plan loans), the distribution may not be in accordance with hardship provisions. The plan administrator is responsible for determining if the need is in fact valid, which requires proof of the need. In addition, the participant must cease making deferrals for a six month period following receipt of the hardship distribution. To avoid these mistakes you should be familiar with your plan’s hardship provision.