401(k) plans are like complicated machinery with a lot of moving parts and a lot of ways that things can go wrong.
While there are many compliance errors that can occur, especially with testing, eligibility, and the plan document, payroll is the root of many potential headaches.
Unlike defined benefit and other defined contribution plans, 401(k)s are forever connected to payroll and participant salary deferrals, and that’s why it’s at the cause of so many plan problems.
1. The late deposit of salary deferrals
The Department of Labor (DOL) has ramped up retirement plan compliance audits. The largest focus for 401k plans for the past few years has been the late deposit of salary deferrals.
The DOL reinterpreted the guidelines of salary deferral deposits a few years back and opined that plan sponsors could no longer depend on the safe harbor guidelines for depositing deferrals before the 15th day of the following month.
The reason for their change was that technology has allowed salary deferral deposits to be made quickly and efficiently, and that particular safe harbor was too long and generous. The DOL, therefore, indicated that plan sponsors needed to deposit participant salary deferrals as soon as possible.
Under the new DOL viewpoint, 401k plan deferrals must be deposited on the earliest date the funds can reasonably be separated from the employer’s general assets.
For some larger companies, the DOL thinks it should be within three business days.
However, it created a safe harbor standard for plans with fewer than 100 participants, which states that regardless of how quickly the sponsor can reasonably make the deposit, the DOL will treat it as timely if made within seven business days following the payroll date.
Even if the plan sponsor is one day late in depositing salary deferrals, they’ve essentially triggered a prohibited transaction. Red flags are then raised, and the sponsor needs to correct it as soon as possible.
Late deposits of participant deferrals and loan payments must be reported on the annual Form 5500/5500- SF filing each year until fully corrected. Delinquent salary deferral deposits often result in follow-up correspondence from the DOL when corrections through their Voluntary Fiduciary Compliance Program have not been completed.
I will say that plan sponsor who informs the government on Form 5500 that they have late deferral deposits (as required under penalties of perjury) are more likely to be audited by the DOL than plan sponsors who make timely salary deferral deposits.
Any plan sponsor who thinks they’ve been late for even one payroll deduction should correct it through the DOL calculator and VFCP program.
2. The compensation problem
The second biggest problem is the compensation issue.
What is it?
It’s when a 401(k)-plan sponsor uses one definition of compensation for salary deferrals and employer contributions, but the plan document says something different.
A good example is when a 401(k)-plan sponsor doesn’t want to allow participants to defer and doesn’t want to count contributions on bonuses.
It’s a big problem when the plan document failed to exclude bonuses as compensation.
Sponsors need to operate their plan according to the terms of the plan document. So not only would the plan be non-compliant, it will have to make corrective contributions for the missed deferral opportunity and any employer contributions associated with the bonus that should have been included as compensation.
Sponsors need to reconcile payroll, the contributions they make, and how the plan document defined compensation to make sure they’re uniform.
Otherwise, the plan sponsor is going to have unnecessary compliance errors.
The problem with compensation errors is that they might be detected many years later. I had one potential client advise me that they had a compensation problem for over 20 years. They didn’t include bonuses as compensation when the plan document said they should, and their third-party administrator (TPA) and auditor failed to discover it.
Mistakes happen, but mistakes that are identified years later are more expensive to fix than errors discovered immediately.
3. Loans and loans and loans
401k plan loans are an attractive feature because participants can access their account balance as the need arises.
But loans are an exemption from the prohibited transaction rules under the Internal revenue Code. Anything that takes loans outside of the exemption makes it a prohibited transaction and therefore taxable.
There are several parts to the exemption that, when violated, turn the loan into a prohibited transaction.
The main issue is that payments are made from payroll. A payroll snafu may happen when the participant decides they need to default on the loan because they can’t afford to pay, or an error occurs and payments aren’t made.
The latter usually happens when there are multiple loans for the same participant and not all receive payments, which turns one or more into a taxable event.
Loans are a tremendous headache because when a default occurs, it’s often detected years later.
One warning about payroll
Payroll is a critical facet of 401(k) plans because of the potential problems it can create. It doesn’t mean, however, that a plan sponsor should necessarily hire their payroll provider as their TPA.
Most payroll providers aren’t effective TPAs, so there is no seamless integration between payroll and TPA services that will eliminate payroll errors. Plan sponsors should, therefore, pick a good payroll provider and a good TPA.
Ary Rosenbaum is an author and ERISA/retirement plan attorney for his firm, The Rosenbaum Law Firm P.C.
He is also the host of That 401(k) Conference, a fun and informative retirement plan conference taking place at Coors Field in Denver on Friday, June 14, 2019, from 9:00 am to 2:00 pm. Special guest: Ryan Spillborghs.
Rosenbaum’s latest book, humbly titled “The Greatest 401(k) Book Sequel Ever,” is available in Kindle and paperback at Amazon.com.
Ary Rosenbaum is an author and ERISA/retirement plan attorney for his firm, The Rosenbaum Law Firm P.C.