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 and have varied definitions for differing 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.
The amount of the QNEC is equal to 50 percent of the employee’s missed deferral opportunity, meaning 50 percent of the amount they should have contributed to the Plan. If the employee also should have received an additional matching amount, that contribution must be corrected at 100 percent of the amount the employee would have received.
If errors are found and fixed promptly, Plan sponsors may reduce the QNEC from 50 percent to 25 percent, or possibly 0 percent, if the following conditions are met:
- The impacted employee must still be employed at time of correction
- The period of failure exceeds three months (if the period of failure is less than three months, no corrected QNEC is required)
- 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 2018-52. If the participant terminates employment before the notice is provided, then this requirement has not been met.
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.