IRS Eases Correction Rules for Missed Employee 401(k) & 403(b) Deferrals

Posted on May 1, 2015

The IRS has eased the requirements for correcting a failure to honor an employee’s election to defer a portion of his or her pay. The new rules make it easier to bring 401(k) and 401(b) plans into compliance where employers fail to honor an employee’s deferral election, and will be particularly helpful to sponsors of plans that provide for automatic enrollment of employees in these plans.

The new rules are in response to critics who claimed that the prior correction rules were too burdensome and inhibited the adoption of automatic enrollment. BCG is part of an industry group (Council of Independent 401(k) Recordkeepers) that met with Treasury Department Representatives twice to make the case for easing these rules.

New Time Period for Correcting Missed Deferrals Under an Automatic Contribution Arrangement. Prior to the change, an employer’s failure to deduct employee deferrals under an automatic contribution arrangement or otherwise because of a payroll glitch or other error or because the employee was not automatically enrolled at the proper time often required the employer to make substantial corrective contributions (50% of the missed deferrals) on behalf of the affected employees. Many thought this created a windfall for those employees since they received the missed deferrals in their pay. An exception was made for deferrals missed and corrected during the first 3 months of the plan year since the employee still had an opportunity to make up those deferrals.

Under the new rule, the timing for correcting missed deferrals with respect to an automatic contribution arrangement is tied to the deadline for filing a plan’s 5500 Annual Report (generally, 7 months after the close of a plan year, but with an automatic 2 ½-month extension). The new rule applies to the employer’s failure to implement an employee’s automatic deferral under an automatic enrollment or automatic deferral escalation. It also applies to the failure to implement an affirmative employee deferral election made in connection with an automatic contribution arrangement.  The employer need not make up the missed deferrals so long as the employer starts to deduct the appropriate deferrals from employees’ paychecks by the first pay day after after the extended for filing the plan’s Annual Report for the year of the failure. However, if the employee notifies the employer of the missed deferral, the employer must start deducting the deferrals from the employee’s pay no later than first pay day on or after the last day of the month following the notification.

As a condition to this relief, an employer must notify all affected employees of the failure and its correction (and other specified information) within 45 days after their deferrals commence.

The employer must also make any matching contributions that would have been made if the employees’ deferrals had commenced at the appropriate time (plus earnings on those contributions calculated as permitted under the correction procedures). The deadline for making these retroactive matching contributions is the close of the second plan year after the plan year in which the operational failure occurred (“Correction Period”).

Rolling Three-Month Exception. The new IRS procedure converts the existing three-month exception described above into a rolling three-month provision. This new rules applies to all missed deferrals and not just those under an automatic contribution arrangement. So long as elective deferrals commence within three months of when they should have commenced an employer need not make up the missed deferrals. This new rule applies regardless of when the missed deferrals took place during the plan year. Of course if the employee notifies the employer of the missed deferrals, the employer must begin deferrals no later than the time described above. Missed matching contributions, plus earnings, must be made no later than the end of the Correction Period.

Failures Lasting More than Three Months. The other new correction method applies to any missed deferrals for a period of more than three months – but only if an employer begins deducting the proper elective deferrals from an employee’s pay no later than two plan years after the plan year in which the failure began. In this case, the employer need only contribute 25% of the missed deferrals instead of 50%. Missed matching contributions must also be made no later the end of the Correction Period.

This new procedure is a welcome relief for employers and should spur the adoption of automatic enrollment features in their plans.  The reduction of the required employer contribution where the missed deferrals are corrected within Correction Period is also very helpful because miss deferrals are usually caught before the plan’s 5500 Annual Report is filed.

The new rules with respect to automatic contribution arrangements apply to failures that occur before December 31, 2020, but it is likely they will continue beyond that time.

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