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10 Common Mistakes in Administering Retirement Plans & IRAs (and How to Fix Them)

10 Common Mistakes in Administering Retirement Plans & IRAs (and How to Fix Them)

Posted on January 16, 2024

Originally published in October 2023

This article has not been updated for current law since the date of its posting on the website. This article is not intended to provide any legal advice. Please seek advice of your professional council.

Any U.S. federal and state tax advice contained in this communication is not intended or written by the Knox Law Firm to be used, and cannot be used by you, for the purpose of: (i) avoiding penalties under the Internal Revenue Code that may be imposed upon you, or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.

The SECURE 2.0 Act - Selected Provisions

Retirement Benefits Changes under SECURE 2.0 Act

The SECURE 2.0 Act was included as part of the Consolidated Appropriations Act of 2023 signed into law on December 29, 2022.

Required Minimum Distributions are delayed beyond the age of 72. As of 2020, under SECURE 1.0, a participant is required to take required minimum distributions (RMDs) upon the later to occur of either reaching the age of 72 or retirement. Under SECURE 2.0, the age of 72 is replaced by the age of 73. This change is effective as of January 1, 2023. Furthermore, starting in 2033, the required age for RMDs is further delayed until the age of 75.

No RMD for Roth Plan Accounts. Starting in 2024, plan Roth accounts are not required to make RMDs. As a result, it is anticipated that fewer plan participants will be rolling over their plan Roth accounts into Roth IRAs, thus leaving more assets in the plan to administer.

Rothification of Catch-Up Contributions for High-Income Earners. Starting in 2024, catch-up contributions for certain high-income taxpayers to their 401(k), 403(b) and governmental 457(b) plans will have to be made on an after-tax basis. High-income earners are those whose wages (as defined in Section 3121(a) of the Code) for the preceding calendar year from the employer sponsoring the plan exceed $145,000, as adjusted for inflation. If the plan does not allow individuals to make catch-up contributions to a Roth account, the catch-up contribution rules will not apply to that plan. That will impact all participants regardless of their wages. In other words, if an employer’s plan includes employees eligible to make catch-up contributions and some of them earned over $145,000 in the previous calendar year, but if the plan does not include a Roth catch-up contribution option, no one would be able to make catch-up contributions.

Enhanced Catch-Ups. Beginning in 2025, SECURE 2.0 allows participants in their early 60s to make enhanced catch-up contributions equal to the greater of either $10,000 or 150% of the regular catch up amount. For example, if the regular catch-up is $7,000 then 150% of $7,000 is $10,500. So, for that year, a 60-year old can contribute $10,500 (which is the larger amount of $10,000 and 150% of the regular catch-up).

Plan Beneficiary who is a Surviving Spouse can Elect to be Treated as the Predeceased Spouse. Beginning in 2024, SECURE 2.0 allows a surviving spouse who is a beneficiary of a retirement plan, to elect to be treated for RMD purposes as the predeceased spouse who was a plan participant. As a result of this election, the surviving spouse can delay RMDs until the predeceased spouse should have reached the age at which RMDs are required. The election may be beneficial to surviving spouses who are older than their predeceased younger spouses. If the election is made, the RMDs would be calculated based on the life expectancy tables by using the Uniform Lifetime Table (which is likely to produce smaller RMDs) rather than the Single Lifetime Table (which is likely to produce larger RMDs). And if the surviving spouse dies before RMDs begin, the surviving spouse’s beneficiaries will be treated as though they were the original beneficiaries on the account.

Option for Employer Match for Amounts Paid by Participants Towards their Student Debt. The law made it clear that beginning in 2024, employers will be able to amend their plans to allow employer matches for amounts paid by participants towards their student debt. Vesting and matching schedules must be the same as if the student loan debt payments had been salary deferrals.

Long-Term Part-Time Employees. Under the SECURE 1.0, individuals with three (3) or more consecutive years of more than 500 hours of service (calculated since 2021) who are 21 years of age by the end of the third year, are required to be allowed to defer to 401(k) plans. SECURE 2.0 shortened the period from three (3) years to two (2) years. Starting in 2025, employees with two (2) consecutive years of more than 500 hours of service and who are 21 years of age, must be allowed to defer to the employer’s 401(k) plan.

Emergency Withdrawals. SECURE 2.0 expanded a list of exceptions to 10% penalty for early withdrawals. One of these exceptions applies to emergency withdrawals. Beginning in 2024, plan participants may withdraw, penalty free, up to $1,000 per year from the retirement plan to cover any unforeseeable or immediate financial needs relating to necessary personal or family emergency expenses. Any additional withdrawals may be taken in subsequent years only if the prior distributions have been paid in full, or cumulative employee contributions and deferrals since the emergency withdrawal equal or exceed the amount of the emergency withdrawal. If neither applies, then the next emergency withdrawal can be made only three (3) years after the previous emergency withdrawal was made.

Emergency Savings Accounts. SECURE 2.0 also allows plan sponsors to add emergency savings accounts to their 401(k) and 403(b) plans. Such emergency savings accounts will be linked to the existing employer plans with individual balances. Only non-highly compensated plan participants can contribute to the emergency savings accounts. The maximum amount held by such emergency savings account is $2,500, but plan sponsors may set a lower balance amount. The IRS is required by law to provide more guidance within twelve (12) months on how to administer such accounts, including how to account for distributions. The contributions are treated as Roth elective deferrals. Congress specifically exempted distributions from emergency savings accounts from the 10% penalty. The plans will be required to allow at least one distribution per month and no fees for distributions may be imposed on at least the first four (4) distributions.

Force-Out Amounts and Self-Correction Program. Force-out amounts are increased from $5,000 to $7,000 after 2023.

The Treasury Department and the Internal Revenue Service (the “IRS”) expect that plan sponsors will amend their plans by the last day of the plan year starting on or after January 1, 2025. So, if you have a calendar plan year, your plan will need to be amended by December 31, 2025. (For governmental plans, the amendments must be made by the last day of the plan year starting on or after January 1, 2027.)

For plan years beginning after 2023, new 401(k) and 403(b) sponsors will be required to auto enroll their eligible employees at no less than three (3%) percent and no more than ten (10%) percent. Unless an employee opts out, his/her contributions will auto increase by one (1%) percent each year after auto enrollment up to ten (10%) percent. Plan sponsors who have (i) ten or fewer employees, or (ii) if the business has been in existence for less than 3 years, or (iii) church plans and governmental plans are exempt from the auto enrollment requirement.

Small employers will have an increased credit to write off start-up costs incurred to set up a retirement plan. Effective for tax years beginning after 2022, employers with 50 or fewer employees can claim the credit over 5 years for start-up costs. The amount of credit is adjusted based depending on whether the employer has fifty or fewer employees, one hundred or fewer employees or more than one hundred employees. No credit is available for employers with more than 100 employees.

The ten (10%) percent penalty for early withdrawals is removed if withdrawals are made as a result of a federally declared disaster and the withdrawal is made within 180 days of the disaster, provided that the participant’s primary residence is within the declared disaster area and the participant has sustained an economic loss as a result of the disaster. After 2023, there is no ten (10%) penalty for withdraws up to the lesser of $10,000 or 50% of the present value of the account by victims of domestic abuse. Additionally, no ten (10%) penalty for withdraws by individuals diagnosed with a terminal illness, if such withdrawals are made within a period of 84 months after a physician certifies the diagnosis.

Impact of the SECURE 2.0 Act and IRS Notice 2023-43 on Retirement Plan Benefits

10 Common Mistakes in the Administration of Retirement Plans and IRAs

SOURCE: Ten (10) Common Mistakes in the Administration of the Retirement Plans ad IRAs

Failure to amend the plan for tax law changes by the end of the period required by the law. This results in a plan failing to operate in accordance with the current law because the plan document has not been amended to affect such change. Currently, the most common law changes that employers have failed to amend their plans for are those employers who use pre-approved plans defined contribution plans who failed to adopt new versions by [July 31,2022]. Employers who use individually designed plans failed to update their plan documents by the end of their applicable remedial amendment cycle as set forth in the appropriate Cumulative List.
Failure to follow the plan’s definition of compensation for determining contributions. Usually, certain types of compensation are excluded, such as bonuses, commissions, or overtime, or certain types of compensation are included where they should have been excluded. This failure can result in participants receiving allocations to their accounts that are either greater than or less than the amount they should have received.
Failure to include eligible employees in the plan or the failure to exclude ineligible employees from the plan.This often occurs in a controlled group situation after a merger or acquisition. Where otherwise eligible employees are excluded, the excluded employees don’t receive an allocation of contributions to which they are entitled. Where ineligible employees are included in the plan, the employer has made additional contributions which it did not need to make to the plan.
Plan loans that don’t comply with IRC 72(p). IRC 72(p) plan loan failures often result from the plan sponsor’s failure to withhold loan payments. Where a plan fails to collect loan repayments from participants, the loan is considered defaulted and the participant should be taxed on the loan in the year of default.
Impermissible in-service withdrawals. These requests relate to both defined benefit and contribution plans. The law provides that distributions to participants can be made upon certain events or the attainment of a specific age. This failure involves the circumstance where a distribution is made to a participant where the law or plan terms do not permit a distribution.
Failure to satisfy IRC 401(a)(9) minimum distribution rules. The law requires that a participant receive a distribution when they attain a certain age. This failure involves the plan not making distributions to participants where they have attained the age for required distributions under the law. The law requires that the participant pay an excise tax of [25%] on the amount of required distribution if it is not made timely. The Service will, in appropriate cases, waive the excise tax if the plan sponsor requests the waiver in appropriate situations.
Employer eligibility failure. This occurs when an employer adopts a plan that it legally is not permitted to adopt. Common situations are where a government adopts a 401(k) plan or a tax-exempt entity (other than a 501(c)(3) entity or a public educational organization) adopts a 403(b) plan.
Failed ADP/ACP nondiscrimination tests under IRC 401(k) and 401(m) not corrected in a timely manner. This failure involves 401(k) or plans with 401(m) contributions whose ADP or ACP tests did not pass and corrective actions were not taken by the end of the following plan year.
Failure to properly provide the minimum top-heavy benefit or contribution under IRC 416 to non-key employees. The law requires that if the account balances or accrued benefits of key employees (typically, owners) comprises a substantial portion of the assets of the plan (generally, 60% of plan assets), non-key employees are entitled to receive a minimum benefit or contribution.
Failure to satisfy the limits of IRC 415. The law limits the amount of contributions a participant can receive in a defined contribution plan (i.e., a 401(k) or profit-sharing plan) and the amount of benefits a participant can accrue in a defined benefit plan. This failure occurs where the employer or its third party administrator does not monitor the amount of contributions allocated or the amount of benefits accrued by participants.”

Planning Opportunities – How to Fix the Mistakes

1. Failure One – Plan has NOT been amended to comply with the current law

As a result, it becomes an individually designed plan if (i) it had an IRS determination letter OR (ii) was adopted by using a pre-approved document. If that is the case, then (i) the plan need to be updated based on the Required Amendments List AND (ii) restated based on preapproved documents. If, however, the plan had never had an IRS determination letter or has never been adopted by using a pre-approved document, then the plan must use Voluntary Compliance Program (“VCP”). Currently, the VCP programs are streamlined and provide Model VCP Compliance Statements. The correction methods are specified in the Model Compliance Statements

2. Failure Two – Employer Does Not Follow the Definition of “Compensation” in the Plan

Profit-Sharing Formula. If the profit-sharing plan uses a fixed contribution formula [e.g. 5% of compensation], and the employee (EE) received less than what he/she should have received, the employer (ER) makes a “make whole” contribution, plus earnings. If the EE received more than what he/she should have received, re-allocate the excess plus earnings to a suspense account within the plan and use in subsequent plan year to reduce ER contribution.

Profit-Sharing Plan with Discretionary Formula. Pro-rata allocation may be used to fix the problem. For example, discretionary contribution formula (e.g. $x allocated pro-rata among participants) is in the plan. The ER has two (2) options to correct: (i) “make-up” or “make whole” contribution plus earnings or (ii) re-allocate from some employees and add to the other employees.

3. Failure Three – Failure to Include Eligible Employees in the Plan

As a result, the EE did not (i) receive non-elective employer contribution, or (ii) have opportunity to defer pre-tax, or (iii) have opportunity to defer Roth, or (iv) have opportunity to catch-up, or (v) the plan failed to implement deferral election (or, improperly implemented deferral election), or (vi) the plan failed to apply automatic deferral. The easy way to fix elective deferrals for ER to contribute Qualified Non-Elective Contribution (“QNEC”) equal to: (i) missed deferral opportunity, (ii) missed after-tax opportunity, (iii) required safe harbor contribution. The missed match can be fixed by ER to make corrective non-elective contribution for missed match. QNEC is pretax (even if correcting a Roth deferral failure). To fix non-elective contributions, ER should make participant whole for
non-elective contributions. SECURE 2.0 Act offers self-correction program in these situations. No QNEC will likely be required if the failure is corrected within 9 ½ months after the plan year.

Another example of failure to include eligible employees in the plan will be the plan failure to delay employee’s entry into the plan. For example, the EE’s entry was delayed until July 1, 2023 where the entry date should have been January 1, 2023. The 2023 compensation equals $50,000 [$4,166.67/month]. The average ADP for NHCEs is 4%. So, based on these facts, the correction will be for the ER to contribute QNEC of $250 (plus earnings)

$1,000 (4% x $25,000) = missed deferral
x 25% [missed deferral opportunity percentage]
$250 = ER QNEC

Would have been $0 if corrected by April 1^st (brief exclusion and/or 3-month correction). The Plan need not re-run the ADP test after correction.

Here is an example how to correct the match. Assume January 1^st entry, exclusion until July 1 and $50k annual compensation and the plan has a matching contribution formula of 100% of elective deferrals not exceeding 4% of compensation, computed on an annual basis. EE would have deferred 5% of compensation from July to December (5% x 25,000 which equaled 2 ½% of compensation for the plan year). Correction for match will be 100% of $1,250 (missed deferral). However, since the match limit is $2,000 [4% of compensation], the ER will make a contribution of $750 ($2,000 – 1,250) plus earnings.

Here is an example to correct Safe Harbor Match. For example, the plan is a safe harbor plan with a basic safe harbor match. If the plan is corrected more than 2 years after the plan year end (PYE) of the failure the plan cannot use 25%. Missed Deferrals equal $750 (3% x 25,000). The proposed correction will be for ER to contribute QNEC of $375 (plus earnings):

$750 (3% x $25,000) missed deferral
x 50%
$375 – missed deferral opportunity

Match correction will be the corrective QNEC equal $2,000 less match amount contributed during the last 6 months of the plan year.

Another example is a failure with Safe Harbor Non-Elective Plan. Assume January 1 entry delayed to July 1 and $50k annual compensation. The plan is an ADP safe harbor plan with 3% safe harbor non-elective contribution. If it is corrected more than 2 years after PYE of the failure, then missed deferrals equal to $750 (3% x $25,000). Also, the corrective contributions:

$375 QNEC – Missed deferral opportunity (50% x $750)
$750 QNEC – Required SH contribution (3% x $25,000)

Failure to include employees is even more complicated in light of recent changes made by SECURE and SECURE 2.0 as related to long term part time (LTPT) employees. On December 20, 2019, President Trump signed into law the Setting Every Community Up For Retirement Enhancement Act of 2019 (the “SECURE” Act), which became effective on January 2, 2020. The SECURE Act introduced the definition of a “long term part time” employee (“LTPT” employee). Unless plan terms provide otherwise, those who have at least 500 hours of service during any of three (3) consecutive 12-month periods and 21 years of age are included in the LTPT employee definitions. The statute specifically excludes: (i) union employees if their retirement benefits were the subject of good faith bargaining; (ii) nonresident aliens without a US source of income; or (iii) who have not reached the age of 21 by the end of the 3^rd consecutive 12-month period. Furthermore, under SECURE 2.0, unless plan terms provide otherwise, those who have at least 500 hours of service during any of two (2) consecutive 12-month periods and 21 years of age are included within the LTPT employee definitions starting on or after 2025.

Correlative failure related to exclusion of employees is a failure to exclude ineligible employees. It can happen if an EE entered before satisfying age/service/entry date, or the ER used the wrong classification. The mistake can be fixed by retroactively amending plan to conform to operation. It is important to remember that amendment to let in only those who came in early will be effective only if: (i) amendment qualified when adopted, (ii) amendment qualified when effective, (iii) early entrants predominantly NHCEs, and (iv) such amendment does not violate the coverage. If the plan sponsor is not eligible to use retroactive amendment (e.g., predominantly HCEs), then the plan would (i) treat the contribution re ineligible EE as excess amount, (ii) distribute deferrals (plus earnings) and (iii) allocate employer contributions to a suspense account.

4. Failure Four – Plan Loan Failure

Here are typical example of loan failures: (i) EE doesn’t pay on time, (ii) ER fails to withhold repayments from wages, (iii) the plan loan fails as written, (iv) the loan amount exceeds Code §72(p) limit (generally $50,000 or ½ vested account), (v) the loan doesn’t require level payments at least quarterly, (vi) the loan term exceeds 5 years (except for principal residence purchase).

For example. EE borrows $10,000 on July 1, 2018 at 6% interest rate. The EE pays $196.14 from each monthly paycheck with the last payment due on 6/1/2023. In January of 2019 ER discovers no withholding of payments. If the ER does not pursue the VCP or self-correct under IRS Notice 2023-43, loan is in default and the amount of the loan is deemed to be distributed on December 31, 2018. As a result, the ER will issue 1099-R for $10,303.07 (outstanding balance on December 31, 2018).

Balance 12/31/2018 $10,303.07
Payments owed $ 980.70
12/31/2018 balance if payments timely $ 9,322.37
Interest ER should pay (4 months at 6% x $980.70) $19.61

Repayment options:
(i) Pay $980.70 and ER withholds $196.14 going forward;
(ii) ER withholds $217.12 paycheck through June 1, 2023; or
(iii) combination of approaches (i) and (ii)

The loan failure can be self-corrected. The plan MUST issue a 1099-R for the year in which the deemed distribution or loan offset occurred. If the failure occurred at the outset of the loan (e.g. excess loan), the employer must pay withholding taxes to the IRS. In addition, CARES Act provided some relief re loan failure due to COVID-19 epidemic. However, the plans need to adopt an Interim Amendment to bring their plan documents in compliance with their operations if, indeed, ER may rely on CARES Act provisions in handling defaulted loans.

ER can always use VCP to fix loan failures. Relief is based on the EE repaying the loan plus interest. That will require a lump sum repayment equal to missed payments. Alternatively, ER will be re-amortizing loan over no longer period than what remains of the original 5-year period. The third option will be the combination of above. If the EE won’t or can’t repay within that window, no reason to file under VCP. ER must pay additional interest that accrues as a result of failure to withhold equal to the greater of plan loan rate or plan earnings rate.

5. Failure Five – Impermissible In-Service Withdrawals

Typically, impermissible in-service withdrawals occur when (i) the participant is not subject to required minimum distributions; or (ii) the plan does not permit in-service distributions, or (iii) the plan makes an impermissible in-service distribution. To fix it the impermissible payment [plus earnings at the plan’s earnings rate] should be returned to the plan by the participant.

6. Failure Six – Failure to Satisfy Required Minimum Distributions Requirements (“RMD”) under Section 409(a)

Apart from all the confusion created by SECURE and SECURE 2.0 as to the timing of RMD, there are two (2) issues related to failed RMD: (i) they create an operational failure for plan, and (ii) trigger penalty for participant. Under SECURE 2.0, the penalty is reduced form 50% to 25% or even 10% depending on when RMD is correct. In some instance, the penalty can be altogether waived for reasonable cause. The plan operational failure can be fixed through self-correction by distributing RMDs. If it is a multi-year failure, the distribution can take into account missed RMDs for prior years in computing amount. With regards to penalties, the EE may request penalty Waiver when filing Form 5329. Also, as a reminder, CARES Act and IRS Notice 2022-53 provided guidance re waiver of missed RMD in 2020 and 2021 due to COVID-19 and the confusion created by SECURE. The ER can use VCP to correct RMDs failure. The value of the VCP is the waiver of the 25% excise tax [SECURE 2.0]. It is a streamlined procedure.

The IRS Proposed Regulations regarding RMDs under § 401(a)(9) of the Code and related provisions in the Federal Register, published on February 24, 2022 (87 FR 10504), provide for two (2) automatic waivers of excise tax on missed RMDs.

The first situation is when (i) the employee (or in the case of an IRA, the IRA owners) died before the required beginning date, (ii) the payee is an eligible designated beneficiary who did not make an affirmative election to use the life expectancy rule but otherwise is subject to the life expectancy rule pursuant to a plan provision or the regulatory default provision that applies in the absence of a plan provision, (iii) the payee did not satisfy the RMD requirements, and (iv) the payee elects for the employee’s or IRA owner’s entire interest to be distributed under the 10-year rule. In that case, once the payee elects the 10-year rule, the payee’s RMD in the tenth calendar year following the calendar year of the employee’s or IRA owner’s death is the entire account balance.

The second situation is when an individual who had an RMD requirement in a calendar year dies in that calendar year before satisfying that RMD requirement. The individual’s beneficiary must satisfy the RMD requirement by the end of that calendar year. However, if that beneficiary fails to satisfy the RMD requirement in that calendar year, then the excise tax for the failure to take the distribution is automatically waived provided that the beneficiary satisfies that requirements no later than that beneficiary’s tax filing deadline (including extensions thereof).

7. Failure Seven – ER Eligibility Failure

This occurs when an employer adopts a plan that it legally is not permitted to adopt. Common situations are where a government adopts a 401(k) plan or a tax-exempt entity (other than a 501(c)(3) public charity or a public educational organization) adopts a 403(b) plan. To fix it, the ER can use VCP Submission process or self-correct under the IRS Notice 2023-43. It is based on streamlined Form 14568-F for 401(k) and 403(b) failures. In addition, the ER must (i) stop all contributions to the ineligible plan, (ii) no new participants are admitted to the ineligible plan, and (iii) the assets remain in trust subject to the distribution restrictions of the ineligible plan.

8. Failure Eight – Non-Discrimination Tests (ADP/ACP) under 401(k) and 401(m)

Good news, such failures can be self-corrected if corrections are made timely. ADP/ACP corrections more than 12 months after the plan year must follow Employee Plan Compliance Resolutions Ssustem (“EPCRS”) procedures. Such failures are considered operational failures, and can be corrected under SCP, VCP or Audit CAP depending on facts. Usually, there are two methods to correct them: QNEC or 1-to-1.

QNEC correction will require to give QNEC to all eligible NHCEs (not exceeding Code Section 415 limit for the year of the failure), with earnings. Allocate pro rata (by compensation) – “bottom-up” not allowed for this correction. If plan has match, there is no need to match QNEC, but plan must pass ACP test.

1-to-1 correction. For example, ER discovers ADP failure from 2 years ago. Correct ADPs would have been HCE = 8.0%; NHCE = 4%, based on the current year method. NHCE total compensation in the year of failure equals $500,000.
HCEs:
X: $150K comp, $15,000 deferrals (10%)
Y: $200K comp, $13,000 deferrals (6.5%)

Corrective distribution amount: (i) reduce X & Y to 6%, (ii) X’s deferrals: $15,000 – $9,000 = $6,000, (iii) Y’s deferrals: $13,000 - $12,000 = $1,000. Corrective distribution amount is $6,000 + $1,000 = $7,000.

Distribute $7,000 (plus earnings) to X and Y: (i) X gets $5,250 + $750 = $6,000 (plus earnings); (ii) Y gets $1,000 (plus earnings).

If, for comparison, ER decided to use QNEC correction method instead, ER contributes $7,000 QNEC plus earnings and allocates to NHCEs pro-rata. ER corrected using QNEC in lieu of 1-to-1 method, the QNEC amount would be: $500,000 x 2% = $10,000 (plus earnings) which will raise NHCE ADP to 6%.

9. Failure Nine – Lack of Top- Heavy Benefit or Contribution under Section 416 to Non-Key Employees

Such failures are considered operational failures. In order to correct them, the ER must contribute the top-heavy contribution plus earnings figured from when contribution should have been made. What happens if a participant has separated and taken a distribution? In this case, the ER must make a supplemental distribution. What happens if a participant has separated and was 0% vested? The answer is the following. The ER must contribute to the plan and the plan will treat such contribution as a forfeiture.

So, the question becomes when does it amount to an operational failure for the employer to fail to contribute top heavy minimums? Unfortunately, there is no definitive answer but failure to contribute at least 12 months after plan year is considered to be the deadline for causing such failure to become an operational failure. The consequences depend on how soon the failure is fixed. If it is fixed after the deadline, such correction is an EPCRS correction and will require contribution of earnings. If the correction is made before the deadline, it is not an EPCRS correction and does not require contribution of earnings.

10. Failure Ten – Exceeding Section 415 Limits

As a general rule, the law limits the amount of contributions a participant can receive in a defined contribution plan (i.e., a 401(k) or profit-sharing plan) and the amount of benefits a participant can accrue in a defined benefit plan.

Here is an example:

EMPLOYER CONTRIBUTIONS

1. Reduce account balance by excess allocations.

EE Deferrals: Distribute back to the employee.

WARNING: The distribution is NOT eligible for rollover, otherwise could trigger excess IRA contribution penalties. The distribution is reported on Form 1099-R and taxable in the year of the distribution. The participant must be provided with a notice that the distribution is an excess amount and does not qualify for favorable tax treatment and not eligible for rollover.

2. If the allocation should have been allocated to other employees, then re-allocate.

3. Otherwise, put excess in suspense account.

4. Adjust for earnings.

5. Use the suspense account to reduce future employer contributions.

6. WARNING: Employer cannot make any contributions until the suspense account is used up.

In order to correct Section 415 violation, the ER must follow the following ordering rules:

Distribute unmatched after-tax;
Distribute unmatched deferrals;
Distribute matched after-tax [associated match placed in suspense account];
Distribute matched deferrals [associated match placed in suspense account]; and
Reduce other employer contributions

Planning Pitfalls: How to Avoid Mistakes

Use the IRS Employee Plans Compliance Resolution System (EPCRS)

As a general rule, EPCRS principles can be summarized as follows:

Correct all taxable years (even if closed)
Restore plan and participants to position they would have been in had the failure not occurred
Should be reasonable and appropriate
Consistent with the Internal Revenue Code (don’t create another violation)
Provide benefits to NHCEs
Keep excess ER contributions in the plan trust

The IRS further explains on its website that “[t]he correction for a mistake should be reasonable and appropriate. The correction method should resemble one of the methods described in the Internal Revenue Code. You should consider all facts and circumstances when determining which method to use. The guide that governs the EPCRS program can be found here.

There are three ways to correct mistakes under EPCRS:

Self-Correction Program (SCP) - permits a plan sponsor to correct certain plan failures without contacting the IRS or paying a fee.
Voluntary Correction Program (VCP) - permits a plan sponsor to, any time before audit, pay a fee and receive IRS approval for correction of plan failures.
Audit Closing Agreement Program (Audit CAP) - permits a plan sponsor to pay a sanction and correct a plan failure while the plan is under audit.

Self-Correction Program

To be eligible for SCP, the plan sponsor or administrator must have established practices and procedures (formal or informal) designed to promote and enable compliance with the law. A plan document alone does not constitute evidence of established procedures.

SCP is available to correct:

Operational problems - the failure to follow the terms of your plan. Rev. Proc. 2019-30, Section 8 describes the factors to consider when determining if operational failures are insignificant. The plan sponsor should follow the general correction principles in Revenue Procedure 2021-30, Section 6. Note that some operational failures can be corrected under SCP via retroactive plan amendments to match the written plan to the plan's operation if certain conditions are met. See Rev. Proc. 2021-30, section 4.05 and Appendix B section 2.07.
Certain problems with the plan document, associated with qualified plans under IRC 401(a) and IRC 403(b), such as the failure to keep it current to reflect changes in the law if its discovered and corrected in a timely manner. See Rev. Proc. 2021-30, Sections 4.01, 4.05, 5.01, 5.02 and 9.02.
Problems with participant loans—defaulted loans that were not paid back in a timely manner, or where a participant received more loans than what was permitted by the plan's written terms/loan policy or where spousal consent was not obtained as required by the plan's written terms. See Rev. Proc. 2029-30, Sections 4.05, 6.07 and Appendix B 2.07.
For 403(b) operational failures that occurred before 2009, you must follow the definition of an operational failure in Rev. Proc. 2008-50, Section 5.02. SCP is not available for other types of errors, like the failure to adopt a written plan or to keep your plan current for recent law changes.
403(b) plan sponsors should follow Rev. Proc. 2021-30 for failures that took place in 2009 and later years and Rev. Proc 2008-50 for failures that took place in 2008 and earlier years.
A plan sponsor that corrects a mistake listed in Appendix A or Appendix B of Rev. Proc 2021-30 according to the correction methods listed may be certain that their correction is reasonable and appropriate for the failure.
If needed, the plan sponsor should make changes to its administrative procedures to ensure that the mistakes do not recur.
When using SCP, the plan sponsor should keep adequate records to show correction in the event the plan is audited.
There is no fee to use the self-correction program.

Voluntary Correction Program

The plan sponsor makes a submission to the IRS via www.pay.gov that:

includes a completed Form 8950,
identifies the mistakes,
proposes corrections using the general correction principles in Rev. Proc. 2021-30, section 6,
proposes changes to its administrative procedures to ensure that the mistakes do not recur,
pays a user fee,
and may include Form 14568, Model VCP Compliance Statement, and Forms 14568-A through 14568-I (Schedules).

The IRS issues a Compliance Statement detailing mistakes identified by the plan sponsor and the correction methods approved by the IRS. The plan sponsor corrects the identified mistakes within 150 days of the issuance of the Compliance Statement. While the IRS is processing the submission, employee plans will not audit the plan, except in unusual circumstances.

Audit Closing Agreement Program

The plan sponsor or plan is under audit. The plan sponsor:

enters into a Closing Agreement with the IRS.
makes correction prior to entering into the Closing Agreement.
pays a sanction negotiated with the IRS. It will not be excessive and will bear a reasonable relationship to the nature, extent, and severity of the failures.
The sanction is determined based on facts and circumstances, including the following relevant factors

The presence of internal controls designed to ensure that the plan had no failures or that such failures were identified and corrected in a timely manner:

Number of affected employees;
Impact on non-highly compensated employees;
whether it's a demographic failure or an employer eligibility failure;
Length of time failure occurred;
The reason for the failure;
The Maximum Payment Amount as defined in sections 5.01, 5.02 of Rev. Proc. 2021-30;
See Rev. Proc. 2021-30, section 14 for additional details and factors;
The sanction paid under Audit CAP should be not be less than the fee paid under VCP.

The IRS website lists very helpful links to correction guides:

IRS Notice 2023-43: Employee Plans Compliance Resolution System (EPCRS)

In May 2023, the IRS issued Notice 2023-43 in response to SECURE 2.0. “This notice provides guidance in the form of questions and answers with respect to section 305 of Division T of the Consolidated Appropriations Act, 2023, Pub. L. 117-328, 136 Stat. 3559 (2022), known as the SECURE 2.0 Act of 2022 (SECURE 2.0 Act), enacted on December 29, 2022. Section 305 provides for the expansion of the Employee Plans Compliance Resolution System (EPCRS), currently set forth in Rev. Proc. 2021-30, 2021-31 IRB 172 …"

Although the Notice does not serve as a comprehensive roadmap for self-correction, it does provide useful interim guidance to plan sponsors. It also makes clear that no self-correction is available to IRA and annuity custodians prior to any revisions of Rev. Proc. 2021-30. Finally, the Notice declines to address recovery of plan overpayments and correction of automatic contribution errors until Rev. Proc. 2021-30 is updated. (SECURE 2.0 permits plan fiduciaries to recover inadvertent benefit overpayments by either reducing future benefit payments or seeking repayment from the participants or beneficiaries. SECURE 2.0 does not penalize plan fiduciaries for choosing not to seek repayment of inadvertent overpayments, provided that future benefits are adjusted accordingly.)

The good news is that plan sponsors may self-correct eligible inadvertent failures related to loans from a plan to its participants by using Rev. Proc. 2021-30 guidance and correction methods. The bad news is that the Notice lists a wide range of failures that cannot be self-corrected before Rev. Proc. 2021-30 is revised. Such list includes, but is not limited to: (i) failure to adopt a written plan; (ii) failure in an orphan plan; (iii) a significant failure in a terminated plan; (iv) a demographic failure corrected by a method other than set forth in the Treasury Regulations; (v) correction of an operational failure that is less favorable to a participant or a beneficiary than the original terms of the plan.

Other good news includes a waiver of certain conditions listed in Rev. Proc. 2021-30 as prerequisite for self-correction. The following do NOT apply as conditions precedent for self-correction: (i) a favorable determination letter for a plan and (ii) a set deadline for correcting significant failures. The IRS Notice has also (i) removed the blank prohibition against self-correction of demographic and employer eligibility failures, (ii) expanded the range of loan failures that can be self-corrected; (iii) allowed employers to continue to correct failures while the plan is under examination provided that self-correction of significant failures had been substantially completed prior to the plan examination, and (iv) permitted self-correction of insignificant failures even if the plan is under the examination.

It is important for the IRS that a plan sponsor shows a specific commitment to implement the self-correction of an identified failure. “The mere completion of an annual compliance audit or adoption of a general statement of intent to correct failures when they are discovered are not actions demonstrating a specific commitment to implement the self-correction of an identified failure.” The IRS allows 18 months from the date the plan sponsor identifies the failure to correct it. A shorter (6 month period) applies to correct the employer eligibility failure. It seems that the 18^-month and 6-month correction periods keep running even if the plan is under examination.

The Notice applies to failures that occurred prior to SECURE 2.0, however, it does not waive any excise tax or additional tax which already applies to the plan. If your plan is subject to penalties and taxes for failures that could have been corrected if the Notice would have been issued earlier, the plan will still need to pay such penalties and taxes.

IRS Notice 2023-43 provides interim guidance on self-correcting eligible inadvertent failures as authorized by SECURE 2.0. The IRS is required, by law, to amend the EPCRS procedures by December 29, 2024. In the meantime, the IRS provided more details to plan sponsors with regard to self-correction.

The current version of EPCRS allows to self-correct only insignificant failures within a specified period of time (usually 3 years from the occurrence of the failure.) Such failures are common among qualified plans. Notice 2023-43 (as required by SECURE 2.0) allows plan sponsors to self correct both, insignificant and significant inadvertent failures within reasonable time (18 months, in general) from the date of discovery of the failure. Furthermore, even if the IRS selected the plan for audit, the plan sponsor can correct the failure as long as the plan sponsor shows a specific commitment to implementing self correction (i.e. meaningful steps are taken to correct the failure by applying Section 6 of Rev. Proc. 2021-30 correction principles and rules of general applicability and, in the discretion of the plan sponsor, using a correction method in Appendix A or B of Rev. Proc. 2021-30) and such self correction occurs within reasonable time of discovering the failure. As a prerequisite for self-correction, the plan sponsor must (i) have practices and procedures reasonably designed to promote overall compliance and (ii) such practices and procedures must be routinely followed.
The failure has occurred because the procedures, while reasonable, were not sufficient or because a mistake was made in following them. The practices and procedures should meet the standards set forth in Section 4.04 of Revenue Procedure 2021-30. Among other things, the procedures should cover (i) keeping plan documents up to date, (ii) following the written terms of the plan, (iii) correctly applying the plan’s definition of compensation, (iv) correctly applying annual limits on elective deferrals, total contributions, covered compensation, and the like, (v) properly calculating employer matching and nonelective contributions, (vi) annual coverage and nondiscrimination testing, and top heavy testing, (vii) timely depositing elective deferrals, (vii) compliance with service crediting rules for eligibility and vesting, (viii) compliance with required minimum distribution requirements, (ix) compliance with joint and survivor annuity requirements, and (x) timely distribution of required participant notices and disclosures. The plan procedures and practices can be established by either plan sponsor or plan administrator. As a practical matter, it is better to have the procedures and policies be established by the plan sponsor since in most cases the plan sponsor is administering the plan.
The IRS Notice 2023-43 has also (i) removed the blank prohibition against self-correction of demographic failures (provided they are corrected under Treas. Reg. 1.401(a)(4)-11(g)) and employer eligibility failures, (ii) expanded the range of loan failures that can be self-corrected (since loan errors corrected with the IRS and DOL, self-correcting under new IRS rules will also count as correcting for DOL. However, SECURE 2.0 allows DOL to establish certain reporting requirements with respect to self-corrected loan errors) ; (iii) allowed employers to continue to correct failures while the plan is under examination provided that self-correction of significant failures had been substantially completed prior to the plan examination, and (iv) permitted self-correction of insignificant failures even if the plan is under the examination. The IRS Notice 2023-43 (i) allows both, insignificant and significant errors to be corrected within reasonable time (18 months) from the date they are identified, (ii) expanded types of errors subject to self correction to certain plan document errors, certain loan failures, employer eligibility failures, and demographic failures.
Even though the IRS did not impose any additional record-keeping requirements under Notice 2023-43, it is reasonable to expect that the IRS will require to provide some documentation upon request to substantiate self-correction. For example, the records should support “(i) the date the failure was identified, the years the failure occurred, and the number of employees affected, (ii) an explanation of how the failure occurred and a demonstration of established practices and procedures in effect when the failure occurred, (iii) identification and substantiation of the correction method and date the correction was completed, and (iv) identification of any changes made to the established practices and procedures to ensure the same failure will not recur.” (Self-Help: the IRS Provides Interim Guidance for Self-Correction under the SECURE Act 2.0, by Katrina McCann, June 15, 2023)
Some commentators highlight factors that may impact the determination whether the failure is significant or insignificant, such as “ (i) whether other failures occurred within the period, (ii) the percentage of plan assets and contributions involved in the failure, (iii) the duration of the failure, (iv) the number of participants affected relative to the number of participants who could have been affected by the failure, (v) whether the correction was made promptly, and (v) the reason behind the failure (e.g. data error, minor arithmetic mistakes.” (Id.) It is also important that the failure is NOT (i) egregious (per Rev. Proc. 2021-30, Section 4.10), (ii) relate to an abusive tax avoidance transaction (per Rev. Proc. 2021-30, Section 4.12(2), or (iii) relate to diversion or misuse of plan assets.
SECURE 2.0 codified the requirement to have practices and procedures in place that ensure compliance with the proper plan administration. Furthermore, in order to avail itself of the self-correction option, the plan sponsor must show that the procedures and practices have been followed and in spite of that, an inadvertent error occurred.
The IRS also made it clear that some errors, regardless how inadvertent they are, may not be corrected. These are: (i) a failure to initially adopt a written plan document (including the failure to adopt a written section 403(b) plan within the required time frame); (ii) a failure in an orphan plan, (iii) a significant failure in a terminated plan, (iv) a demographic failure corrected using methods not set forth in the Treasury Regulations; (v) an operational failure corrected by a plan amendment conforming the terms of the plan to its prior operations in a manner that is less favorable for a participant or beneficiary than the original terms of the plan,(vi) a failure in an ESOP that has certain tax consequences under Code Section 409, (vii) excess contributions to a SEP or SIMPLE IRA that allows the excess to remain in the plan, and (viii) failures in SEPS or SIMPLE IRAs that do not use the IRS model plan documents and even for mode plans when excess contributions remain in the IRA account, and (ix) coverage and certain nondiscrimination testing failures that are not corrected in a method prescribed by IRS regulations. This restrictions does not apply to ADP/ACP testing for 401(k) plans, which may be corrected by self correction. (Id., Most Expanded Self-Corrections Available Immediately for Workplace Retirement Plans, but Not for IRAs, by Joan Vines and Norma Sharara, June 13, 2023)
In addition, the IRS confirmed that certain requirements imposed currently by EPCRS will NOT apply since they are not required under SECURE 2.0 to qualify for self-correction, such as (i) the requirement that the plan have a favorable determination letter, (ii) the general prohibitions on self-correction of demographic failures, employer eligibility failures and certain plan loan failures, (iii) the requirements that self-correction of significant failures be substantially completed before the plan or plan sponsor is under examination; and (iv) the limited correction period for significant failures (the last day of the third plan year following the plan year for which the failure occurred). (Id.)
Finally, the IRS did NOT waive a requirement to submit VCP application to request a waiver of an excise tax or additional tax caused by the failure even though such failure is self-corrected, and pay the user fee for VCP application, or requesting for a closing agreement through the Voluntary Closing Agreement Procedure (for issues that cannot be corrected through EPCRS).
It is important to remember that, as expanded, EPCRS program does NOT allow to correct all plan errors, only to correct plan qualification errors. Errors like (i) wrong fees charged to plan participants’ accounts, late deposits of employee salary deferrals, or late filings of Form 5500, or lack of top-hat notices cannot be corrected through EPCRS. (Late deposits of salary deferrals are corrected under the Department of Labor’s Voluntary Fiduciary Correction Program. Late filings of Form 5500 are corrected under the Department of Labor’s Delinquent Filer Voluntary Compliance Program.)
Since Notice 2023-43 explicitly provides that IRA custodians may NOT self-correct failures until EPCRS is formally updated, the IRA providers still need to think about positioning themselves to take advantage of self-correction process. SECURE 2.0 expressly (i) waives the excise tax on failures to take required minimum distributions, and (ii) permits nonspouse beneficiaries to return distributions to inherited IRAs in certain cases involving service provider’s inadvertent errors, if such errors are corrected. While waiting for further guidance from the IRS, the IRA provides should have reasonable practices and procedures in place. It is hoped for that the following IRA administration errors will be allowed to be self-corrected: (i) IRA contributions to incorrect customer accounts, (ii) IRA contributions credited to the wrong tax year, (iii) failure to withhold proper taxes from IRA distributions, (iv) transfers and rollovers to incorrect customer accounts, (v) failure to complete requested transactions by required deadline, (vi) failure to properly title IRA account or checks related to an IRA distribution, (vii) wrong IRA transaction processed, not following IRA owner instructions, and (ix) errors involving allocating inherited IRA assets, just to name a few.
To stay in compliance, the plan sponsors are encouraged to regularly: (i) review and update plan documents to reflect law changes, plan amendments and administration changes, and (ii) conduct compliance reviews of plan administration, timely and fully correct any failures that are identified and fully document the review and all steps involved in making corrections.

Other Recent Developments as Related to Correction of Plan Failures

IRS Notice 2023-54: Transition Relief and Guidance Relating to Certain RMDs

On July 14, 2023, the IRS issued Notice 2023-54 in response to comments and questions related to changes made by SECURE 2.0 Act. “This notice provides transition relief for plan administrators, payors, plan participants, IRA owners, and beneficiaries in connection with the change in the required beginning date for required minimum distributions (RMDs) under § 401(a)(9) of the Internal Revenue Code (Code) pursuant to § 107 of the SECURE 2.0 Act of 2022 (SECURE 2.0 Act), enacted on December 29, 2022”.

It provides guidance related to certain specified RMDs for 2023. In addition, this notice announces that the final regulations that the Department of the Treasury (Treasury Department) and the Internal Revenue Service intend to issue related to RMDs will apply for purposes of determining RMDs for calendar years beginning no earlier than 2024.

SECURE 2.0 changed the required beginning date from age 72 to ages 73 through 75, depending on the birth year. Plan administrators, payors, plan participants, IRA owners, and beneficiaries were not equipped to address the changes in timely manner. In addition, the Proposed Regulations issued by the IRS in February of 2022 as related to RMDs caught a number of providers by surprise for not only applying the rules retroactively to calendar year of 2022, but also clarifying RMD rules for those who inherit retirement accounts after the participant/IRA owner’s required beginning date. Specifically, the so-called “10-year rule” applies differently to RMDs under the Treasury Department and the IRS Proposed Regulations regarding RMDs under § 401(a)(9) of the Code and related provisions in the Federal Register, published on February 24, 2022 (87 FR 10504), based on whether the owner died before or after the required beginning date.

As such, the IRS granted relief to the plan administrators, payors, plan participants, IRA beneficiaries by waiving excise taxes on missed RMDs for 2022 due to interpretation of SECURE Act 10-year rule as not requiring any RMDs until the 10^th year of the owner’s death. Also, the Notice 2023-54 allows the IRA owners who attain age 72 in 2023 to roll over by September 20, 2023 the RMDs that they received in 2023 (as originally required by SECURE).

Treasury Proposed Regulations RE: Rules for Retirement Plan Forfeitures

Federal Register, Feb. 27, 2023

The IRS issued the proposed regulations on how the retirement plans must be using forfeitures. The rules apply both, to the defined contributions plans and defined benefit plans.

Forfeitures can arise under a defined contribution (DC) plan that includes vesting schedule for certain employer contributions or by correcting annual contribution percentages (ACP) testing failures. Currently, DC plans generally just use forfeitures by the end of the plan year in which they arise. However, some plans held on to forfeitures for more than a year.

The proposed rules would (i) set a firm deadline for DC plans to use these forfeitures (that is within 12 months after the end of the plan year in which the forfeiture arose), and (ii) require the plan sponsors to specify in the plan document how and when forfeiture amounts must be used.

The proposed regulations provide for three alternative uses of forfeitures: (i) paying plan administrative expenses, (ii) reducing employer contributions, including restoring inadvertent benefit overpayments and conditional forfeiture participant accounts, or (iii) increasing benefits in other participants’ accounts in accordance with plan terms, including fuding ACP/actual deferral percentage (ADP) corrective and safe harbor contributions (as permitted by 2018 final regulations). The IRS cautioned the plan sponsors to stay away from specifying only one option since doing so could result in an operational failure. The forfeitures may exceed the amount needed for the specified purpose in a given year and it would be prudent to have a couple of options available on how to use forfeitures.

The proposed rules also provide for a transition period for forfeitures that occurred prior to 2024. Unused forfeitures from earlier years will be treated as if they arose in the 2024 plan year and therefore, plan administrators will have at least 12 months after the end of the 2024 plan year to use those amounts.

With regard to the defined benefits plan, ERISA’s defined benefits (DB) plan minimum funding rules automatically reflect anticipated forfeitures in the calculation of the current year’s required contributions. The current rules as applied to DB plans, require such plans to use forfeitures to offset required employer contributions as soon as possible. The proposed rules would eliminate this old requirement and better fit the forfeiture rules to the funding rules.

Department of Labor Amendment of Voluntary Fiduciary Correction Program

Although the DOL initiated the amendment of the program in November of 2022, it became of more importance in light of SECURE 2.0 provisions related to self-correction The DOL is restating the VFCP in its entirety, aimed to expand the VFCP by expanding the types of errors eligible for correction under the VFCP and self-correction, as well as amending the related prohibited transaction class exemption.

SECURE 2.0: Reduction in Missed RMD Excise Taxes, Elimination of Pre-Death RMD for Roth Amounts, Increased Cash-Outs, Forgoing Overpayment Recovery

For tax years beginning after December 29, 2022, the excise tax penalty for failing t take an RMD decreases from 50% of the amount that should have been distributed to 25% of such amount. The penalty may be further reduced to 10% if, within two years following the missed RMD and prior to receipt of a notice of assessment from the Internal Revenue Service, the individual receives all past due RMDs, files the necessary tax returns, and pays the applicable taxes.

Additionally, beginning with the 2024 tax year, RMDs are not required during a participant’s lifetime from Roth-designated plan accounts. This change does not apply to distributions required by April 1, 2024 for those reaching the RMD age in 2023.

Beginning in 2024, the dollar limit applied to mandatory cash-outs for former employees will increase from $5,000 to $7,000.

Effective December 29, 2022, plan fiduciaries will not fail to comply with ERISA, and plans will not lose qualification status, when a fiduciary chooses not to recoup mistaken overpayments. If a fiduciary chooses to seek repayment, SECURE 2.0 imposes certain limits on the amount that can be recovered (10% cap) and prohibits charging interest.

Author: Nadia A. Havard

Originally published in October 2023