By June 30, 2022, businesses with 5 or more California employees must either enroll in CalSavers, a state-managed system of Roth IRA accounts, or establish their exemption from CalSavers by adopting 401(k) or other retirement plans of their own. Other states have implemented or are rolling out similar auto-IRA programs. Below are some potential pitfalls for new plan adopters that business owners should be aware of, and, where possible, take steps to avoid.
- Immediate top-heavy status. The “top-heavy” rules compare the combined plan account balances of certain owners and officers, called “key employees,” with the plan account balances of all other plan participants (non-key employees). If the key employee account balances make up 60% or more of the combined plan account balances of all participants, the plan is top-heavy and the plan sponsor is required to make minimum contributions (generally equal to 3% of compensation) to the accounts of all non-key employees. A plan can be top-heavy in its first year of operation, although it is more commonly a result of large account balances accumulated over time by long-term key employees, versus smaller accounts held by high-turnover, lower paid employees. Top-heavy status is particularly likely to arise in a family-owned business, as family members of owners count as key employees, but the problem is not limited to this scenario. Businesses that anticipate a potential top-heavy problem should consider adopting safe-harbor 401(k) plan designs, as a basic safe-harbor matching or non-elective contribution will satisfy minimum top-heavy contribution requirements. A SIMPLE-IRA plan is also exempt from top-heavy requirements, provided you have 100 or fewer employees.
- ADP/ACP testing failure. A similar and more common problem, failure of the Actual Deferral Percentage or ADP test, occurs when the average rate of elective deferrals made by Highly Compensated Employees exceeds the average rate of elective deferrals made by non-Highly Compensated Employees by more than a permitted amount. (A related test, the Actual Contribution Percentage test, applies to matching contributions.) Highly Compensated Employees (HCEs) are persons who own more than 5% of the company sponsoring the plan at any time during the current or prior year, or who, for the prior year, earned above a set dollar amount. (For 2022, the amount is $135,000 and applies to 2021 earnings.) Correcting testing failures will involve refunding amounts to HCEs, or making additional contributions to non-HCEs. Fortunately there are a number of preventive measures to take, including using a safe harbor contribution formula, using a “top 20%” election to define HCEs, using automatic enrollment at a meaningful percentage of compensation (such as 5% or higher), and robust enrollment meetings and tools to engage employees with savings potentials under the plan.
- Late deposit of elective deferrals. When you run payroll and pull employee elective deferrals from pay, you have a deadline within which to invest them under your 401(k) plan, which is the point at which they are considered to be “plan assets” under ERISA. Investment is generally is denoted as a “trade date” by your plan’s recordkeeper, whether Fidelity, Vanguard, or the like. If you have under 100 participants as of the beginning of your plan year (counting those who are eligible to participate even if they don’t actively do so) you have seven business days to get from pay date, to trade date. For larger plans, the normal deadline to invest is as soon as elective deferrals can reasonably be segregated from your general assets. (An outside deadline of 15 business days after the end of the month following the month in which the elective deferrals would have been payable in cash applies in the event of extraordinary circumstances interrupting normal payroll functioning.) If you fail to meet the seven business-day or “as soon as” deposit deadline, your retention of employee funds constitutes a “prohibited transaction” and an excise tax is payable to the IRS. Additionally, the Department of Labor views it as a fiduciary breach. It is possible to seek relief from the excise tax and from potential fiduciary liability by participating in the Department of Labor’s Voluntary Fiduciary Compliance Program or VFCP. Late deposits of employee elective deferrals (and loan repayments) must be disclosed each year on your Form 5500 Return/Report, which in turn could trigger further inquiry, so compliance with your applicable deposit deadline is important.
- Plan audit requirement. As we covered in an earlier post, a business sponsoring a brand new 401(k) plan may be required to obtain an audit report on the plan’s operations and finances, prepared by an independent qualified public accountant or IQPA, at an annual expense of $5,000 – $15,000 or more. These reports generally are required for plans with 100 or more participants as of the first day of the plan year, counting those who are eligible to participate whether or not they actually do so. Proposed regulations for Form 5500 might change that rule, to count only those with plan account balances, but they have yet to be finalized and put into effect. Until that time, businesses sponsoring new plans that will cover 100 or more eligible participants need to prepare for the audit process, both in terms of budgeting dollars for the cost, and time to gather responses to the auditor’s questionnaires. New auditing standards going into effect this year put increased responsibilities on plan sponsors to account for plan operations and documentation.
The above information is a brief summary of legal developments that is provided for general guidance only and does not create an attorney-client relationship between the author and the reader. Readers are encouraged to seek individualized legal advice in regard to any particular factual situation. © 2022 Christine P. Roberts, all rights reserved.
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