One of the most common retirement plan errors is a missed deferral opportunity, or MDO. This occurs when an employer fails to execute an employee’s election to defer amounts to a qualified retirement plan.
When this happens, taxable compensation the employee could have deferred is paid to the employee as wages instead. As a result, the employee misses the opportunity to accumulate tax-free earnings on the amount that should have been deferred.
Timing for Executing Deferrals
The timing for executing employees’ deferral elections is detailed in the plan document and summary plan description. These elections are usually executed on the first day of the month or quarter, or on another date as specified in the plan document.
Missed deferral opportunities can result from a number of different causes, but there are three main scenarios where they tend to occur most often:
- Election implementation: The employee elects to contribute to the plan but the election isn’t implemented by the sponsor. For example, an employee might elect to have 5% of the employee’s pay contributed to a retirement plan starting on January 1 but this doesn’t happen due to a payroll oversight.
- Employee eligibility: The employee has met the plan’s eligibility requirements but is not given the opportunity to make a deferral in a timely manner. For example, an employee might become eligible to participate in a retirement plan on June 1 but the employee isn’t given the opportunity to do so until September 1.
- Compensation definition: An incorrect definition of compensation is used to calculate an employee’s deferrals. For example, the plan document might state that total compensation should be used in calculating deferrals, but bonuses aren’t included in the deferral calculations.
Using EPCRS to Correct MDOs
Fortunately, correcting an MDO is a relatively simple and straightforward process. The IRS offers a roadmap for correcting MDOs via the Employee Plans Compliance Resolution System, or EPCRS.
There are five steps involved in correcting an MDO using the EPCRS:
- Determine the amount of the MDO. In other words, how much of the taxable compensation paid to the employee should have been deferred? If the participant made a deferral election, this is simply the amount of compensation that should have been deferred. If the participant didn’t make a deferral election, it is the average deferral rate of the participant’s group as defined by highly compensated or non-highly compensated employees for 401(k) plans.
- Calculate the corrective qualified nonelective contribution, or QNEC. Corrective QNECs are intended to compensate participants for the tax benefits they missed out on due to the MDO. The amount of the QNEC will depend on how much time has elapsed between the initial missed deferral and when the deferral election is corrected.
If the correct deferral withholding begins within three months of the initial missed deferral, no corrective QNEC is required. If the corrective deferral withholding begins after three months of the initial missed deferral but within two years, the corrective QNEC will be 25% of the MDO. And if the corrective deferral withholding begins more than two years after the initial missed deferral, the corrective QNEC will be 50% of the MDO.
- Calculate the corrective qualified matching contribution, or QMAC, associated with the MDO. In addition to the corrective QNEC, you must also determine the amount of corrective QMAC the employee missed out on due to the MDO. The plan’s match formula is used to determine the amount of the missed match, and 100% of the missed match must be corrected and deposited as a nonelective contribution.
- Adjust corrective contributions for investment gains. If the participant had an active plan account during the period of the error, the account’s actual rate of return should be used to calculate investment gains. Otherwise, the published rates of return for the funds selected should be used. Other options include using the rate of return for the plan as a whole, the rate of return for the plan’s default investment or the Department of Labor’s online calculator.
What if there were investment losses during the period of the error? While you’re permitted to make adjustments for losses, the cost of determining the amount of these losses might be more than the savings you would realize.
- Deposit the resulting amount in the participant’s account. Once you’ve completed all these calculations, you should deposit the corrective contributions into the participant’s account as quickly as possible. If you don’t already have QNEC or nonelective sources set up in your recordkeeping system, create these before making the deposit so you can track the corrective amounts.
Important note: While amounts in your plan’s forfeiture account may be used to fund QNECs and QMACs, plan sponsors should confirm that the provisions in the plan document do not prohibit the use of forfeitures for this purpose.
Straightforward Process, Complex Calculations
While correcting MDOs is a fairly straightforward process, the calculations involved can get complex. Depending on how much time has elapsed since the initial missed deferral and the amount of money involved, the IRS may want to review the correction to make sure it’s accurate.
Special Rules for Plans with Auto-Enrollment
Retirement plans that feature auto-enrollment do not have to make a corrective qualified nonelective contribution (QNEC) for MDOs if the following conditions apply.
- Failure to implement automatic deferral does not exceed 9½ months after the plan year of failure.
- Correct deferrals begin by the first payment of compensation on or after a 9½ month period, or the first payment of compensation on or after the last day of the month after the month when the participant makes notification of the MDO.
- The correction applies for employees making an affirmative election.
- Affected employees receive notice of the failure within 45 days of the date that correct deferrals begin.
- The plan makes adjustments for investment gains and matching contributions.
Contact us if you would like to discuss MDO corrections in more detail.