401(k): Plan Error: Eligible Employee Not Given the Opportunity to Make an Elective Deferral Election!

401(k) Elective Deferral

You walk up to the coffee bar at work one morning where Derek and Rebecca are congratulating Jack for his two-year work anniversary.   You join into the conversation and reminisce on how quickly the time seems to fly by, at which point Jack asks when he can start contributing to the company 401(k) plan.  About that time, the hairs start to pop up on the back of your neck.  Your plan’s eligibility period is only one year so Jack should have already been given a chance to make a 401(k) elective deferral.  This is the point in the conversation where you realize there may have been an over sight in offering Jack the opportunity to start contributing to the plan.  Ugh!!  Now what?

How to fix the mistake:

Corrective Action:

Generally, if you didn’t give an employee the opportunity to make elective deferrals to a 401(k) plan, you must make a qualified nonelective contribution (“QNEC”) to the plan for the employee. This contribution must compensate for the missed deferral opportunity. The corrective QNEC is an employer contribution that’s intended to replace the lost opportunity to a participant who wasn’t permitted to make elective deferrals. The QNEC must be 100% vested and subject to the same distribution restrictions as elective deferrals. Forfeitures can’t be used for QNECs.

To determine the amount of the QNEC, you must first determine whether the employee is a highly compensated employee (HCE) or a non-highly compensated employee (NHCE).  The amount of the QNEC is equal to 50% of the employee’s missed deferral determined by multiplying the actual deferral percentage for the employee’s group (HCE or NHCE) in the plan for the year of exclusion by the employee’s compensation for that year.

Employer D sponsors a 401(k) plan with eight participants. The plan uses a calendar plan year. The plan has a one-year-of-serviceeligibility requirement and provides for January 1 and July 1 entry dates. Jack, whom Employer D should’ve allowed the opportunity to make elective deferrals on January 1, 2012, wasn’t given that opportunity until January 1, 2013. Jack was a NHCE with compensation for 2012 of $80,000. The ADP for 2012 was 10% for HCEs and 8% for NHCEs. Employer D found this mistake in 2013.

Employer D must make a corrective contribution for the 2012 missed deferral opportunity. Jack’s missed deferral is equal to the 8% ADP for NHCEs multiplied by $80,000 (compensation earned for the portion of the year in which Employer D erroneously excluded Jack, January 1 through December 31, 2012). The missed deferral amount, based on this calculation is $6,400 ($80,000 x 8%). The missed deferral opportunity (corrective contribution) is $3,200 (50% multiplied by the missed deferral of $6,400). Employer D must make a corrective contribution of $3,200, adjusted for earnings through the date of deposit, for Jack.

Correction programs available:

Self-Correction Program (“SCP”):
The example shows an operational problem because Employer D failed to follow the plan terms by not giving Jack the opportunity to participate in the plan for the plan year. If the other eligibility requirements of SCP are satisfied, Employer D may use SCP to correct the failure.

  • No fees for self-correction.
  • Practices and procedures must be in place.
  • If the mistakes are significant in the aggregate:
    • Employer D needs to make a corrective contribution by December 31, 2014.
    • If not corrected by December 31, 2014, Employer D isn’t eligible for SCP and must correct under VCP.
  • If the mistakes are insignificant in the aggregate, Employer D can correct beyond the two-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 under “Corrective Action.” Employer D makes a VCP submission according to Revenue Procedure 2013-12. The fee for the VCP submission is $750 (because Employer D’s plan has 20 or fewer participants). When making a VCP submission, Employer D should include Forms 8950 and 8951 and consider using the model documents in Revenue Procedure 2013-12 Appendix C.

Audit Closing Agreement Program:
Under Audit CAP, correction is the same as under “Corrective Action”, Employer D and the IRS enter into a closing agreement outlining the corrective action and negotiate a sanction based on the maximum payment amount.

How to avoid the mistake:

  • Review your plan document for the definition of “employee” and provisions of employee eligibility.
  • Provide proper training about the plan document to in-house personnel who determine employee eligibility.
  • Look at your payroll records for the total number of employees, birth dates, hire dates, hours worked, and other pertinent information. Also inspect Form(s) W-2 and state unemployment tax returns and compare employee data on these records with the payroll records to see if employee counts and data are accurate.
  • Establish protocols and a corrective action plan that will be triggered when errors are identified.

 Additional Resources:

Reference materials
401(k) Plan Fix-It Guide
401(k) Plan Overview
EPCRS Overview
401(k) Plan Fix-It Guide (pdf)
401(k) Plan Checklist

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