Summertime Blues for Your 401(k) Plan, Pt. 1

Summertime is for fun, relaxation and a break from work, but it is also a crucial period for calendar year 401(k) plans. Form 5500 Annual Return/Reports are due July 31 for these plans, and even if an extension to October 15 is obtained, the summer months are when plan operations and finances are under scrutiny.  This is particularly true for “large” plans – those with 100 or more participants on the first day of your last plan year. (Note that special transition rules apply when switching from small plan to large plan Form 5500 filing status and back again, under the “80/120 rule.”  A good explanation of the rule is found here.)   Sponsors of large plans must engage an independent qualified public accountant (IQPA) and attach the auditor’s report to their Form 5500. 

As a benefits attorney, I associate summer with calls from plan sponsors whose auditing CPAs have identified operational failures and other plan errors that require correction under Internal Revenue Service and Department of Labor voluntary compliance programs, including self-correction, when available.  This is the first in a series of five posts covering the 401(k) mishaps that are as reliable a feature of my summers as are the 4th of July, outdoor barbecues and sunscreen.

Error No. 1:  Mismatching Definitions of Compensation

Disconnects between payroll procedures, and the way that your 401(k) plan defines “compensation” for purposes of salary deferrals and employer contributions, generate a significant number of plan operational failures that I see. 

Examples include adding payroll codes to your system without applying participants’ deferral elections and employer contribution to those new payroll amounts, or carving out categories such as bonuses, commissions, and overtime from your plan’s definition of compensation, without stopping deferrals and employer contributions from those amounts.  Whole categories of pay – for instance, tips recorded on credit cards – can sometimes be overlooked in plan operations, as well.  These errors can be corrected fairly simply but the corrections can be expensive and/or time consuming if the errors cover multiple years. 

The best recommendation I can make to avoid compensation-based errors in operating your 401(k) plan is to use Form W-2, Box 1 as your plan’s definition of compensation, with no exclusions (other than gift cards or cash rewards, if your company uses them) and to regularly revisit your payroll codes and procedures to make sure that all pay items that appear in Box 1 are counted for purposes of participants’ salary deferrals and loan repayments. 

Specifically, you should consider holding a meeting each year, or more frequently, among human resources and payroll personnel (in-house or out-sourced) to review the definition of compensation in the Adoption Agreement, on the one hand, and a list of all payroll codes, on the other. Revisit this exercise every time you modify payroll practices, your payroll vendor or software, or of course any time you change the plan’s definition of compensation. 

If your plan defines compensation in a way that involves carve-outs, be especially careful to ensure that the salary deferrals and employer contributions are not applied to the payroll code amounts that correspond to the exclusions, whether bonuses, commissions, overtime, or other items. 

Be mindful, as well, that certain pay items may be excluded from “safe harbor” definitions of compensation, such as cash and/or non-cash fringe benefits, reimbursements or other expense allowances, and moving expenses, but that other exclusions, such as overtime, will trigger the need for annual testing of the definition of compensation under nondiscrimination rules. 

Lastly, there is a good bit of confusion over the scope of certain categories referenced in the safe harbor definitions of compensation, such as nontaxable fringe benefits, and differential wage payments.  As used in an adoption agreement, differential wage payments generally will relate to military service and are not the same as shift differentials.    When in doubt about any definition of compensation issue, check with your third party administrator, ERISA attorney or other benefits professional.  You want your only headache next summer to be from an ice cream cone, not your 401(k) plan.

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. © 2021 Christine P. Roberts, all rights reserved.

Photo credit:  Krissara Lertnimanorladee, Unsplash

State Auto-IRA Programs: What Employers Need to Know

California and four other states (Connecticut, Illinois, Maryland and Oregon) have passed legislation requiring employers that do not sponsor employee retirement plans to automatically withhold funds from employees’ pay, and forward them to IRAs maintained under state-run investment programs. Provided that these auto-IRA programs meet safe harbor requirements recently defined by the Department of Labor in final regulations, the programs will be exempt from ERISA and employers cannot be held liable for investment selection or outcome.  The DOL has also finalized regulations that would permit large cities and other political subdivisions to sponsor such programs where no statewide mandate exists; New York City has proposed its own such program, tentatively dubbed the New York City Nest Egg Plan.

In light of this growing trend, what do employers need to know about auto-IRA programs?   Some key points are listed below:

  1. Some Lead Time Exists. Even for state auto-IRA programs that become effective January 1, 2017 (e.g., in California and Oregon), actual implementation of employee contributions is pushed out to July 1, 2017 (in Oregon) and, in California, enrollment must wait until regulations governing the program are adopted. The California program, titled the California Secure Choice Retirement Savings Program, also phases in participation based on employer size. Employers with 100 or more employees must participate within 12 months after the program opens for enrollment, those with 50 or more within 24 months, and employers with fewer than 50 employees must participate within 36 months. These deadlines may be extended, but at present the earliest round of enrollment is anticipated to occur in 2019.
  2. Employer Involvement is Strictly Limited. The DOL safe harbor prohibits employer contributions to auto-IRAs and requires that employers fulfill only the following “ministerial” (clerical) tasks:
    • forwarding employee salary deferrals to the program
    • providing notice of the program to the employees and maintaining contribution records
    • providing information to the state as required, and
    • distributing state program information to employees.  Note that in California, the Employment Development Department will develop enrollment materials for employers to distribute, and in addition a state-selected third party administrator will collect and invest contributions, effectively limiting the employer role to forwarding salary deferrals.
  3. Employers Always Have the Option of Maintaining their Own Plan. Generally the state auto-IRA programs established to date exempt employers that maintain or establish any retirement plan (401(k), pension, SEP, or SIMPLE), even plans with no auto-enrollment feature or employer match used to encourage employee salary deferrals. Therefore employers need not be significantly out of pocket (other than for administrative fees) to avoid a state auto-IRA mandate. Employers should bear in mind that an employer-sponsored retirement program, even if only a SEP or SIMPLE IRA, helps to attract and retain valued staff, and should consider establishing their own plan in advance of auto-IRA program effective dates for that reason.
  4. Penalties May Apply. California’s auto-IRA program imposes a financial penalty on employers that fail to participate.   The penalty is equal to $250 per eligible employee if employer failure to comply lasts 90 or more days after receipt of a compliance notice; this increases to $500 per employee if noncompliance extends 180 or more days after notification. The Illinois auto-IRA program imposes a similar penalty.
  5. Voluntary Participation in Auto-IRA Program May Create an ERISA Plan. One of the requirements of the DOL safe harbor is that employer participation in auto-IRA programs (referred to as “State payroll deduction savings programs” be compulsory under state law. If participation is voluntary, an employer will be deemed to have established an ERISA plan. In theory, this rule could be triggered when an employer that was mandated to participate later drops below the number of employees needed to trigger the applicable state mandate (for instance, a California employer that drops below 5 employees), but continues to participate. The DOL leaves it to the states to determine whether participation remains compulsory for employers despite reductions in the number of employees.   The DOL also notes that, under an earlier safe harbor regulation from 1975, an employer that is not subject to state mandated auto-IRA programs can forward employees’ salary deferrals to IRAs on their behalf without triggering ERISA, provided that the employee salary deferrals are voluntary and not automatic.   The DOL final regulations can be read to suggest that a payroll-to-IRA forwarding arrangement that is voluntary and that meets the other requirements of the 1975 safe harbor will constitute a pre-existing workplace savings arrangement for purposes of exempting an employer from a state-mandated auto-IRA program.
  6. The Trump Administration Will Likely Support Auto-IRA Programs. Early and necessarily tentative conclusions are that the Trump Administration will continue to support the DOL’s safe harbor regulation exempting auto-IRA programs from ERISA, as well as other state-based efforts to address the significant savings gap now known to confront much of the country’s workforce.   One unknown variable is the degree to which the Trump Administration will be influenced by opposition to the programs mounted by the financial industry. Until the direction of the Trump Administration becomes clearer, employers that do not currently maintain a retirement plan should track auto-IRA legislation in their state or city and otherwise prepare to comply with a state or more local program in the near future, ideally by adopting their own retirement plan for employees.