Mistake Find the mistake Fix the mistake Avoid the mistake 3. You didn't use the plan definition of compensation correctly for all deferrals and allocations. Review the plan document definition of compensation used for determining elective deferrals, employer nonelective and matching contributions, maximum annual additions and top-heavy minimum contributions. Review the plan election forms to determine if they're consistent with plan terms. Corrective contribution, or reallocation or distribution. Perform annual reviews of compensation definitions and ensure that the person in charge of determining compensation is properly trained to understand the plan document. Because your plan may use different definitions of compensation for different purposes, it's important to apply the proper definition for deferrals, allocations and testing. A plan's compensation definition must satisfy rules for determining the amount of contributions. One of those rules is that the amount of compensation considered under the plan can't exceed $345,000 in 2024 ($330,000 in 2023, subject to cost-of-living adjustments for later years). This limit is described in IRC Section 401(a)(17). You must follow the plan document compensation definitions. Compensation generally includes the pay a participant received from the employer for personal services for a year including: Wages and salaries Fees for professional services Other amounts received (cash or non-cash) for personal services actually rendered by an employee, including, but not limited to: Commissions and tips Fringe benefits Bonuses The Plan's terms may include all or a portion of compensation for purposes of determining an employee's allocation or salary reduction contribution. In addition, your plan may need to ensure that compensation used for testing complies with applicable statutes. For example, a plan might preclude employees from making deferrals from overtime income. However, if overtime is primarily paid to nonhighly compensated employees, then the plan may not be able to use the plan's restricted definition of compensation for the actual deferral percentage (ADP) test. The plan would have to ensure that the definition of compensation complies with the requirements of IRC Section 414(s) and may need to include overtime for this purpose. Thus, it's critical that the plan monitor its operation to ensure that the terms of the plan are followed to determine an employee's elective deferral or other allocation. In addition, it's critical to monitor the plan to ensure that the compensation used for different testing purposes (e.g., ADP, section 415, top heavy) comply with applicable statutes. How to find the mistake Review the plan document to determine if you're using the proper compensation for allocations, deferrals and testing. Many plan sponsors operate their plan based on a plan summary of the definitions and operational requirements. As the plan is amended, the compensation definition may change while the plan continues to operate as it had previously. Review the plan sections dealing with allocations and deferrals. Each plan contains sections, either in the plan document or in an adoption agreement, that discuss how the plan must make allocations and deferrals. This section may say, for example, "Employees may defer up to 15% of their Compensation…" You then have to go to the plan section containing definitions and find the "Compensation" definition. Spot-check deferrals and allocations to see if you're using the correct compensation. Some of these definitions can get complicated with expense reimbursements, car allowances, bonuses, commissions and overtime pay that is or is not included in the definition of compensation. If you have a plan with a complicated definition of compensation, you may want to develop a worksheet to calculate the correct amounts. How to fix the mistake Corrective action There are a couple of ways to make corrections when you have improperly allocated amounts because you didn't follow the plan definition of compensation. If you've determined that an employee made excess elective deferrals, give the participant a distribution of the excess deferrals plus earnings. However, if net earnings are negative then, the plan sponsor will need to make an additional contribution to the participant's account to reimburse it for the loss. In addition, matching contributions related to the excess deferral (adjusted for earnings) should be forfeited and based on plan terms, either reallocated to other participants or to an unallocated account to be used for future matching contributions. If there are improper profit-sharing contributions, forfeit and based on plan terms reallocate the contributions plus earnings to plan participants or to an unallocated account to be used for future profit sharing contributions. If you've determined that an employee made deferrals that were less than what should have been made had the correct compensation amount been used, then a corrective contribution needs to be made to the employee's account within the plan. The employee would receive a corrective qualified non-elective contribution (which is an employer contribution in which the employee is fully vested) equal to 50% of the missed deferral (i.e., the difference between the amount that should have been deferred based on the use of correct compensation and what was deferred). In addition, the employee would receive a corrective employer matching contribution, if applicable, equal to the difference between what the employee would have received if the correct elective deferral was made and the actual matching contribution. Finally, the employee would receive a corrective employer contribution to the extent that he or she received a profit sharing allocation that was less than what he or she would have been entitled to had the correct compensation been used. All corrective contributions must be adjusted for earnings. For failures found and fixed promptly, plan sponsors have the option to reduce the corrective contribution for the lost opportunity cost from 50% of the missed deferral to 25% under certain conditions. For additional details, see Mistake #6 of the 401(k) Fix-it Guide. Example 1: Employer Z sponsors a 401(k) plan with six participants with total plan assets of $375,000. The plan definition of compensation for deferrals and allocations was amended, effective 2005, to exclude bonuses. The plan provides that unallocated forfeitures are to be used for future contributions. For the 2019 plan year, Employer Z improperly included bonuses in compensation when determining allocations and deferrals. Three highly compensated employees each had base compensation of $120,000 and a $30,000 bonus. Each of these highly compensated employees had deferral percentages of 6% of compensation and the plan provides for a fixed profit-sharing allocation of 5% of compensation to each participant's account. The plan provides for a 50% matching contribution for deferrals up to 6% of compensation. Each of the three employees properly received a profit-sharing allocation equal to 5% of their $120,000 compensation ($6,000), but improperly received an allocation equal to 5% of the $30,000 bonus ($1,500). Each of the three employees properly deferred 6% of their $120,000 base compensation ($7,200), but improperly deferred 6% of the $30,000 bonus ($1,800). Each of the three employees properly received a matching contribution of 3% of their $120,000 base compensation ($3,600), but improperly received an allocation equal to 3% of the $30,000 bonus ($900). For each employee, Employer Z should forfeit the profit-sharing allocations of $1,500 adjusted for earnings and reallocate the forfeited amounts to an unallocated account to use for profit-sharing allocations in future years. For each employee, Employer Z should forfeit the matching contributions of $900 adjusted for earnings and reallocate the funds forfeited amounts to an unallocated account to use for matching contributions in future years. Employer Z must distribute the improperly contributed elective deferrals of $1,800 adjusted for earnings to each of the three employees. However, if the earnings are negative, then Employer Z must make an additional contribution to the plan so that the affected plan participants don't suffer a financial loss with regard to the excess deferrals incorrectly paid to the plan. Correction programs available for Example 1 Self-Correction Program The example illustrates an operational problem because Employer Z didn't follow the plan terms by including bonuses in compensation when determining plan allocations. If the other eligibility requirements are satisfied, Employer Z may use SCP to correct the mistake. No IRS imposed user fees for self-correction. Practices and procedures must be in place. If the mistakes are significant in the aggregate: Employer Z needs to complete correction by December 31, 2022. If not corrected by December 31, 2022, Employer Z isn't eligible for SCP and must correct under VCP. If the mistakes are insignificant in the aggregate, Employer Z can correct beyond the three-year correction period for significant errors. Whether a mistake is insignificant depends on all facts and circumstances. Voluntary Correction Program Correction is the same as described under SCP. If the plan is not under audit, Employer Z makes a VCP submission. Employer Z's plan's had less than $500,000 in plan assets, so the user fee for the VCP submission made in 2018 is $1,500. When making the submission, Z must include Forms 8950 PDF and 8951 PDF and consider using the model documents set forth in the Form 14568 series. VCP user fees may change in subsequent years. Audit Closing Agreement Program Under Audit CAP, correction is the same as under SCP. Employer Z and the IRS enter into a closing agreement outlining the corrective action and negotiate a sanction The sanction under Audit CAP is based on facts and circumstances, as discussed in Section 14 of Revenue Procedure 2021-30. Example 2: Employer Y sponsors a 401(k) plan with plan assets that exceed $500,000 but are less than ten million dollars. The plan definition of compensation for deferrals and allocations was amended, effective 2005, to include overtime. For the 2019 plan year, Employer Y improperly excluded overtime compensation when determining allocations and deferrals. Three non-highly compensated employees each had base compensation of $30,000 and $10,000 in overtime income. Each of these non-highly compensated employees had deferral percentages of 4% of compensation and the plan provides for a fixed profit-sharing allocation of 5% of compensation to each participant's account. The plan provides for a 50% matching contribution for deferrals up to 6% of compensation. Each of the three employees properly received a profit-sharing allocation equal to 5% of their $30,000 compensation ($1,500), but in error, didn't receive an allocation equal to 5% of the $10,000 overtime income ($500). Each of the three employees properly deferred 4% of their $30,000 base compensation ($1,200), but in error, the 4% election didn't extend to their overtime incomes of $10,000 ($400). Each of the three employees properly received a matching contribution of 2% of their $30,000 base compensation ($600), but in error, didn't receive the matching contributions they would have been entitled to had deferrals been made from their overtime incomes. If the 4% elective deferrals were made from their overtime incomes, they would have been entitled to receive an additional matching allocation equal to 2% of the $10,000 in overtime income ($200). For each employee, Employer Y should make additional profit-sharing contributions of $500 plus earnings. For each employee, Employer Y should make an additional qualified non-elective contribution of $200 (or 50% of the missed deferral of $400) plus earnings. Employer Y should make an additional employer matching contribution of $200 plus earnings to each of the three employees In terms of the missed elective deferrals, other correction methods may be acceptable to fix that part of this mistake. See Mistake #6 of the 401(k) Fix-it Guide for details. Correction programs available for Example 2 Self-Correction Program The example illustrates an operational problem because Employer Y didn't follow the plan terms by excluding overtime compensation when determining plan allocations. If the other eligibility requirements are satisfied, Employer Y may use SCP to correct the mistake. No IRS imposed user fees for self-correction. Practices and procedures must be in place. If the mistakes are significant in the aggregate: Employer Y needs to complete correction by December 31, 2022. If not corrected by December 31, 2022, Employer Y isn't eligible for SCP and must correct under VCP. If the mistakes are insignificant in the aggregate, Employer Y can correct beyond the three-year correction period for significant errors. Whether a mistake is insignificant depends on all facts and circumstances. Voluntary Correction Program Correction is the same as described under SCP. If the plan is not under audit, Employer Y makes a VCP submission. Employer Y's plan had assets that exceed $500,000 but less than ten million dollars, so the user fee for the VCP submission made in 2022 is $3,000. When making the submission, Y must include Forms 8950 PDF and 8951 PDF and consider using the model documents set forth in the Form 14568 series. VCP user fees may change in subsequent years. Audit Closing Agreement Program Under Audit CAP, correction is the same as under SCP. Employer Y and the IRS enter into a closing agreement outlining the corrective action and negotiate a sanction. The sanction under Audit CAP is based on facts and circumstances, as discussed in Section 14 of Revenue Procedure 2021-30. How to avoid the mistake Perform annual reviews of the plan operations. If the plan document is amended, check the definitions against the old document, noting any differences. Have a centralized person or department responsible for maintaining all plan documents. If you amend your plan document, communicate those changes to everyone involved in the plan's operation. Plan sponsors should develop an internal communication mechanism to timely and accurately advise plan administrators and outside service providers (outside plan consultant, actuary and/or third party administrator/record keeper) of changes. Provide proper training of in-house personnel who determine compensation to understand the plan document. Know what your third party administrators have agreed to provide. They may be relying on you for information, such as compensation and deferral amounts used in their work. Retain a copy of your third party administrator service contract including any updated contracts; and keep a summary of what's being supplied to the plan by the third party administrator, actuary or consultant. Keep this service contract and summary with the person responsible for maintaining all plan documents. Try to simplify your plan's definition of compensation and use the same definition for multiple purposes. 401(k) plan Fix-it Guide 401(k) plan overview EPCRS overview 401(k) plan checklist PDF Additional resources
