Insights

What to Consider When Planning for a 401k Audit

From PP&Co Audit Director Destiny Flood

Today we’re taking a deep dive into some common pitfalls identified during audits of 401k and defined contribution benefit plans. Plan Sponsors are responsible for adhering to proper plan compliance as part of their fiduciary responsibilities, and several compliance areas are required. A 401k audit performed by a qualified CPA can be very valuable to help management determine areas to strengthen internal controls and plan compliance.

The annual report for employee benefit plans, Form 5500, must be filed at the end of each fiscal year by the Plan Administrator/Plan Sponsor. There is a long version for “large” benefit plans, and a short version for “small” benefit plans. Per the IRS, to be considered a small benefit plan, you must have fewer than 100 eligible participants at the beginning of the plan year. The number of plan participants includes active participants, eligible (but not currently participating) employees, and retired, separated, or deceased employees who are currently receiving benefits under the plan.

An audit is required for all “large” plans and is triggered based on the “80-120 rule,” as it is commonly known, which states that the number of eligible participants can rise as high as 120 before an audit is required. This rule can help small- and medium-sized organizations avoid the plan audit requirement while focusing on growing the business. A 401k audit is required once there are greater than 120 eligible participants on the first day of the plan year, and every year thereafter if there are at least 100 eligible participants.

The due date for filing Form 5500 is the last day of the seventh month after the plan year ends (July 31 for a calendar year plan), and can be extended by filing Form 5558, which will grant a 2.5 extension (October 14 for a calendar year plan).

Below are some best practices that management of Plan Sponsors and those who have fiduciary responsibility over the Plan should consider when preparing for a 401k audit:

  • Conduct a review of plan compliance, either internally or using an independent firm, to identify common pitfalls.
  • Conduct an internal review of common pitfalls can help ensure that the provisions of the plan document are being followed.
  • When selecting a firm to perform the audit, ensure that the firm has the required experience and qualifications. For example, consider selecting a firm that is a member of the AICPA Employee Benefit Plan Audit Quality Center.

The common compliance areas tested during a 401k audit are as follows:

  1. Participant data and eligibility
  2. Participant contributions
  3. Loans
  4. Distributions

Now we’ll address the common findings during compliance testing…

Participant data and eligibility 

  • Missing personnel data
    • Proper employee personnel files must be maintained to verify participant demographic information. The demographic information within the personnel files must match the data in the employee census report. This is required for all participants with account balances in the plan, therefore maintaining personnel files for terminated employees is often also required.
    • Recommendation
      • Management should review controls in place to maintain personnel information and investigate potential cloud based electronic storage. Typically, maintaining current executed Form I-9s is sufficient.
    • Incorrect eligibility dates
      • Not timely enrolling participants when they become eligible or elect to enroll, or not enrolling or receiving opt-out forms if the plan has an auto enrollment feature.
      • Recommendations
        • A 401k plan overview should be part of each employees onboarding process, and it is highly encouraged to use online enrollment features with the Plan Administrator, also known as a Third-Party Administrator (“TPA”).
        • Plan Sponsors should also perform reviews of the plan documents at least annually in order to ensure that HR and Payroll are applying the correct eligibility provisions.

Participant Contributions:

  • Not following the Plan’s correct definition of compensation
    • Errors in calculating participants’ elected deferrals and employer matching contributions are common
    • Each Plan has a specific definition of compensation that must be followed when calculating elective deferrals and employer match deferrals.
    • For example, commonly bonuses, overtime pay, or commissions may be excluded from deferrals per the plan documents.
    • For terminated employees – not calculating the final paycheck correctly (some plans exclude final vacation payout from eligible compensation)
    • Recommendation
      • Review plan document and consider reviewing with TPA to potentially update the definition of compensation to be equal to taxable wages (W2 standard wages)
    • Changes to participant elective deferral rates are not updated timely.
      • Recommendations
        • Have a control in place for payroll to verify deferral percentages when processing payroll.
        • Work with TPA to receive reports from online deferral changes timely before processing payroll.
        • Require that participants only make deferral change elections online to avoid errors in processing manual changes.
      • Employer matching contributions aren’t made to all eligible employees.
      • Matching contributions are not provided to employees who meet the eligibility requirements. For example, if a participant must be employed for 90 days before they are eligible for matching contributions, there must be controls in place to ensure the matching contributions start when they become eligible.
      • Recommendation
        • Review safe harbor employer contributions and other employer match eligibility requirements within the Plan’s Adoption Agreement.
      • Delinquent Participant contributions and timely remittances:
        • One of the most common pitfalls is regarding timely payroll and loan repayment remittances and is a common red flag by the Department of Labor (DOL). The DOL can flag all remittances as untimely based on the shortest deferral date that occurred during the year. For example, if one payroll deferral was remitted by the 3rd business day, all other remittances during the year greater than 3 business days can be considered delinquent. Delinquent contributions are also required to be reported on the annual Form 5500 filings and are considered prohibited transactions.
        • Recommendations
          • Remit all payroll deferrals within 3-5 business days.
          • Ensure that a written remittance policy in in place that is adhered to.
          • Review with TPA how to manually process payroll remittances after each payroll cycle.

Loans:

  • Participant loans that are not within the IRS guidelines or are over the allowable limit. The maximum amount that the plan can permit as a loan is (1) the greater of $10,000 or 50% of the participant’s vested account balance, or (2) $50,000, whichever is less. (temporarily increased to $100k for COVID related loans during 2020).
  • Participant loans must be repaid over a period of 5 years or less. A loan that is taken for the purpose of purchasing the employee’s principal residence may be able to be paid back over a period of more than 5 years. A common pitfall is not withholding loan repayments with each payroll, which can cause loans to be delinquent.
  • Participant loans that are not paid back according to the repayment terms is treated as a distribution from the plan and is taxable as such
  • Terminated employees are required to repay their loan balance within a reasonable time period. If the loan is not repaid, the loan balance should be processed as a deemed distribution which is subject to standard distribution tax withholdings. A common pitfall identified is that terminated participants still have loans outstanding after termination and the deemed distributions are not processed timely.
  • Recommendations
    • Ensure that participant loans meet the guidelines of the IRS
    • Set up automatic payment deferrals
    • Put a policy in place for processing terminated participant’s deemed distributions in conjunction with HR termination checklist

Distributions:

  • Required Minimum Distributions – Either paying them timely or at all. Required Minimum Distributions (RMD) for participants that reach retirement age per the IRS.
    • Normally, the RMD for a participant who is not a 5% owner is the April 1 following the end of the calendar year in which the latter of two events occurs:
      • The participant reaches age 70½ or age 72 from the SECURE Act after 2020
      • The participant retires.
    • For a participant who is a 5% (or more) owner the age limit is regardless of whether they retire by the end of that year.
  • Hardship Distributions: Processing hardship distributions that do not satisfy the plan provisions relating to hardship distributions, or not verifying or keeping adequate paperwork to approve qualified hardship withdrawals in accordance with plan documents.
  • Tax withholdings: A common pitfall is not withholding taxes on participant distributions, other than qualified rollovers.
  • Distribution requests are not timely processed.
  • Recommendations
    • Plan Sponsors should carefully monitor the age of all participants, including terminated participants with unpaid vested benefits, who are approaching age 70 for processing RMDs.
    • Work with the TPA to set up distribution requests and processing through the online TPA site.
    • Ensure that tax withholding election forms are maintained.
    • Other recommendation – for administrative purposes to eliminate large numbers of former employees with balances maintained in the plan, we also recommended to work with the Company’s TPA to process force out distributions for small balances (typically balances less than $5k)

Proper plan compliance for 401k and defined contribution benefit plans can be complicated. If you’re a Plan Administrator, it’s critical to establish proper planning and procedures to better ensure compliance.

Still have questions? Contact Destiny at dflood@ppandco.com or (408) 287-7911 to determine the best course of action.

 

Sources: https://www.irs.gov/retirement-plans/correcting-plans-errors-find-plan-errors,   https://www.irs.gov/retirement-plans