Failure to Withhold Elective Deferrals
Rev. 04/15/11; E-mail Alert 2011-6

A common error in plan administration occurs when an employee does not have the correct amount of deferrals withheld from pay because of their employer's misunderstanding of the retirement plan’s definition of compensation.  These errors typically involve compensation such as bonuses and commissions, which are paid in addition to an individual’s regular rate of pay.  This article will discuss the suggested IRS correction when an employer fails to withhold deferrals from an individual’s bonus pay.  The article will also cover how enhancements made to the “Bonus Option” section of McKay Hochman Co. Inc.’s nonstandardized Prototype Adoption Agreements for the EGTRRA restatement will reduce the likelihood of this error occurring in the future.

Example of Missed Deferrals on a Bonus
John elects to make an elective deferral of 10% of compensation for the 2009 plan year.  The employer's plan does not exclude any type of compensation. The employer, however, mistakenly fails to withhold deferrals from John’s annual bonus paycheck made on December 31, 2009.  The plan also provides matching contributions equal to 100% of elective deferrals that do not exceed 6% of compensation.  This error is discovered in 2011 during an audit of the 2009 plan year. What is the IRS’s correction procedure?

Correction
The above facts are an example of an operational error caused by the employer's failure to follow the terms of the plan by not withholding elective deferrals from bonus pay.  Appendix B of Rev. Proc. 2008-50, Employee Plans Compliance Resolution System (EPCRS), contains IRS’s recommended procedure to correct a failure to withhold deferrals and the procedure for correcting the associated match.

Under EPCRS, the employer is to make a corrective contribution (called a Qualified Nonelective Contribution or QNEC) equal to John’s missed deferral opportunity.  The missed deferral opportunity is defined as being equal to 50% of an employee’s missed deferral and must be contributed as a QNEC (adjusted for earnings).  Appendix B §2.02(1)(a)(ii)(B)(2)

This QNEC amount represents what is called the “missed or lost opportunity” cost to the improperly excluded employee deferrals. It is based on an IRS analysis showing that an employee who received cash instead of making deferrals would lose a tax-free buildup equivalent to 50% of the deferral. Note that if matching contributions are also lost, the full amount of the lost deferrals will be used to calculate the matching contribution for the improperly excluded employee deferrals. The matching contribution is also to be a qualified contribution and may be made as a QNEC, rather than a QMAC. Appendix B §2.02(1)(a)(ii)(D)(2)

Missed Deferral Correction, With Associated Match

• John’s bonus: $10,000
• Missed deferral: $1,000
• Missed deferral opportunity (50% of missed deferral): $500, plus earnings
• Missed Match formula 100% of deferrals up to 6%: $600, plus earnings

Under EPCRS, the employer is to contribute a QNEC in the amount of $1,100, plus earnings.

Rule Exception
The IRS provides a special rule under Appendix B §2.02(1)(a)(ii)(F) where an employer would not need to make a corrective contribution with respect to missed elective deferrals if:

• The employee has at least nine months left in the plan year to make contributions, and
• The employee is able to contribute the full amount that would have been withheld had the failure not occurred.

This exception does not apply to a missed matching contribution.  If an employer makes an error that qualifies under this exception, then the employer will not have to contribute missed elective deferrals, but the employer must contribute a corrective QNEC for the missed match.

Limitations
When fixing these types of errors, special attention must be paid to ensure that a corrective contribution does not cause the participant to exceed any applicable plan-specific or statutory limit.

MHCO Adoption Agreement Bonus Option
The “Not applicable” option within the “Bonus Option” section of the EGTRRA adoption agreement has been expanded to provide two options. Each of these options are followed by an explanation defining why the option is being chosen. 

This expansion was made to prevent the employer from making the above type of error. which occurred in two possible ways under prior documents. In certain cases, the employer chose the "bonus option not available option"and incorrectly interpreted it to mean that deferrals could not be made on bonuses. A different employer error occurred when an employer chose the bonus option and inserted a "0" as the percent that could be deferred on the bonus. In both cases, the employer thought that their plan did not permit deferrals on bonuses. However, that is not the case as the correct method of not permitting deferrals on a bonus is to exclude bonuses from the definition of compensation. Such an exclusion requires the ratio compensation test to be passed.

Of course, sometimes the employer simply does not withhold deferrals on the bonus without completing the bonus option section at all and without excluding bonuses from compensation in the document. This type of operational error may still be a challenge.

An overview of the bonus option choices (listed below as EGTRRA bonus option) follows. When the first option (elective deferrals from bonuses are prohibited) is elected,  an election to exclude bonuses from Compensation must have been made in the Compensation definition section.  Standardized adoption agreements may not exclude bonus payments (or any other elements of compensation) from the eligible Compensation definition for elective deferral purposes under any circumstances.

The second option plainly states for the employer that deferrals in the amount of the participant's existing deferral election must be made on any bonus payments, and that participants are precluded from making a separate deferral election for bonus payments. The applicable adoption agreement provisions appear below.

The third option permits the employer to have a separate salary deferral election for just the bonus limited to the percentage or dollar amount inserted by the employer. If the employee does not file a separate bonus election, the employer is required to withhold deferrals based on the salary deferral election already being used for each payroll.

EGTRRA  Nonstandardized 401(k) Bonus Option
1. Not applicable. The Plan’s definition of Compensation excludes bonuses from deferrable Compensation for both Elective Deferrals and Roth Elective Deferrals.

2. Not applicable.  Participants are not permitted to make a separate deferral election and the Participant’s deferral amount elected on their Salary Deferral Agreement will also apply to any bonus received by the Participant for any Plan Year.

3. The Employer permits a Participant to amend his or her deferral election to defer to the Plan an amount not to exceed ________% (may be no more than 100%) or $________ [may be no more than the Code Section 402(g) limit and Code Section 414(v) limit, if applicable] of any bonus received by the Participant for any Plan Year.

 

 

GUST Nonstandardized 401(k) Bonus Option
1. Not applicable.

2. Bonuses paid by the Employer are included in the definition of Compensation, and the Employer permits a Participant to amend their deferral election to defer to the Plan, an amount not to exceed ________% or $________ of any bonus received by the Participant for any Plan Year.

 

For more on this subject come to our Retirement Plan Insights seminar.