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Your business is successful, and you are lucky enough to be able to offer your employees a 401k plan. You set up the plan with a nationally well-known 401k plan administrator a few years ago, and one of your internal employees handles the plan management in additional to her payroll duties. It really is that simple.
Except it isn’t.
401k plans can be complicated.
401k plans are governed by ERISA, a highly complex set of statutes and regulations that impose mandatory updating, reporting, and record keeping requirements on employers that maintain them. Noncompliance can result in tax penalties, fees, and even disqualification of your 401k plan entirely, resulting in negative tax consequences for both an employer and its employees. And even if your 401k administrator handles many of the administrative and record-keeping duties, if an error is made, it is you (the Employer) that is held responsible. With your employees’ retirement funds at stake, here are five things you should ask your 401k plan administrator and/or internal employee handling your 401k plan.
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New Employees:
How are we notifying new employees that they are eligible for the 401k plan? Do we have a special letter? And have we notified all employees who may be eligible? Failure to notify employees that they are eligible for an employer 401k plan is a common error we see. Although correctable, failure to notify eligible employees can result in plan disqualification/termination, unless corrected by making catch up contributions for the missed employees. -
Tax Returns:
Did the 401k file its required tax returns for each year the plan is in existence. Almost all 401k plans are required to file yearly tax returns. Much like an individual, failure to file the tax return can result in significant tax penalties, and, in extreme cases, disqualification of the 401k plan.
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Plan Updates:
When was the last time our plan was updated? The IRS requires that a 401k plan be updated for changes in ERISA and other laws. In the past, each 401k plan was on a six year updating cycle. However, now the IRS requires that amendments published by the IRS on its website be made annually. Some plan administrators automatically provide updated plan documents, but it is your responsibility to ensure those amendments are adopted and reflected in your records. Failure to make required plan updates can disqualify the plan, and will make it difficult to terminate the 401k plan if your business merges or is purchased by another business.
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Participant Loans:
If your 401k plan allows participants to take out loans from their 401k, are the loans being administered correctly and in line with ERISA Rules? ERISA has very strict requirements regarding loans to participants of a 401k plan. Generally, the participant must treat the money as a loan and pay interest and principal quarterly for it to qualify. We commonly see plan administrators approve a participant loan, but fail to police collecting quarterly payments and ensuring that the loan has a promissory note, among other errors. If not properly managed, a participant loan can be considered income (and taxable) to the participant in the year of the loan error. For example, if the loan is not paid quarterly, the entire loan amount might be considered taxable income to the participant. For the same reason, failure to require a formal promissory note can also cause problems.
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Rouge 401k Plan:
If your business has purchased or been purchased by another business, you also must consider if older 401k plans and retirement plans have been terminated correctly. A 401k plan, like most benefit plans, must be terminated and/or adjusted during a sale or purchase of your business. The plan termination process includes providing proper notice to plan participants, making pre-termination updates and amendments to the 401k plan, filling final tax returns, and approving corporate resolutions terminating the plan.
You might be tempted to simply roll all employees from your old 401k plan to the new one, and move on with business. However, a 401k plan, even one with allegedly 0 participants, is still a 401k plan, and you (as the employer) can be liable for (1) not notifying employees they are eligible; (2) failing to file tax returns; and (3) not making required plan updates, among other problems. Don’t let a rouge 401k plan derail your business.
Consequences for Non-Compliance and Fixing 401k Problems:
The consequences for various types of 401k non-compliance can be quite severe. Consider the following two scenarios:
- ABC, Inc. adopted a 401k plan in 2006, but has not made required updates to the plan. When this is discovered in 2016, the IRS determines that the 401k plan lost it tax protected status in 2014. Each employee of ABC, Inc. with funds in the 401k now has a huge tax bill, because they must now pay income tax on the entire amount in the employee’s retirement account. If each employee has $100,000.00 in retirement, that’s $33,000.00 or more per employee in taxes.
- DEF, Inc. adopted a 401k plan in 2006, but did not file tax returns in 2012, 2013, and 2014. The error is discovered in 2015 by the IRS. The IRS assesses a penalty of over $40,000.00 against the employer ($25.00 per day each return is late, to a maximum of $15,000 per return, plus interest).
Our Recommendation
For both of the above, if the errors had been caught by the employer and fixed through one of the various Department of Labor and IRS compliance programs available, many of these extreme tax consequences and employer penalties could have been avoided.
Not surprisingly, we believe that a regular 401k plan audit by an experienced attorney can help uncover administrative problems and plan feature failures that might otherwise derail the successful plan. Virtus law offers 401k audit and compliance services, including audits ancillary to mergers, asset purchases, and stock purchases. We also offer assistance with termination of 401k plans, where appropriate.
To comply with the U.S. Treasury regulations, we must inform you that (i) any U.S. federal tax advice contained in this article was not intended or written to be used, and cannot be used, by any person for the purpose of avoiding U.S. federal tax penalties that may be imposed on such person and (ii) each taxpayer should seek advice from their tax adviser based on the taxpayer’s particular circumstances.