Imagine the following situation: A business that sponsors a 401(k) plan is unable to attract enough employees to the plan for two years running, and fails the average deferral percentage (ADP) discrimination test.  As a result, highly compensated employees (HCEs) must take back contributions, losing out on an opportunity to contribute the maximum into retirement. 

In such a case, some advisors may rush in with an almost knee-jerk recommendation—“Put in automatic enrollment”— not anticipating how this choice, if wrongly implemented, could prove to be a costly one. 

With the 1996 Small Business Job Protection Act and, later, the 2006 Pension Protection Act, Congress endorsed an employer’s ability to mandate savings by its employees by simply taking a small percentage of each paycheck and depositing it into the retirement plan. “Auto” enrollment generally sidesteps annual discrimination tests and HCEs may maximize their retirement contribution annually. 

On its face, auto enrollment can seem like a great solution. . .

. . .  That is, unless the employer “forgets” to withhold from employee paychecks, for example, after failing to tell its payroll company to make deductions from employee gross pay. . .  or the employer acquires another company, and although the plan document requires that new employees contribute 3% of their paycheck automatically, the employer neglects to enroll them in the plan.  

The legal/audit/TPA compliance cost of such missteps is exorbitant.  What once would have been employee payroll money deposited into the plan is now money that company itself  has to contribute, with any match, plus interest.  This mandatory correction is how the IRS and Department of Labor punish this type of forgetfulness and, over a period of years, the cost of these mistakes can add up.  Advisors who fail to provide adequate education on the impact of auto enrollment on daily operations are likely to find themselves with disgruntled clients.

The moral of the story: When proposing auto enrollment, be sure to follow through with implementation details or your client — and your relationship — may suffer the consequences.

Last week, at a Joint Meeting of the IRS's top officials with ERISA/tax attorneys and accountants from across the country, the IRS announced a pilot program that targets companies with at least 2,500 participants.  Colleen Patton, the IRS's Area Manager for the Pacific Coast, says the pilot program has rolled out in her region, and the IRS expects to expand the program across the nation's remaining four geographic areas (Northeast, Mid-Atlantic, Great Lakes, and Gulf Coast). 

Under this program, the IRS hones in on a large plan sponsor (greater than 2,500 participants), rather than one specific qualified retirement plan. Thus, whereas a company usually worried about whether the IRS would audit a qualified retirement plan it sponsored, that same company, if targeted, will now have to worry that the IRS will audit all of the company's qualified retirement plans in just one examination.  Indeed, it is not atypical for one company to sponsor several 401(k) plans and several defined benefit plans and perhaps an ESOP too . . . in this case and under this pilot program, the IRS would examine all those plans together.  

Large companies: brace for FULL IRS audit of all retirement plans at once

A targeted company should expect the IRS to conduct an extensive review of all of its qualified plans' procedures, processes, and systems (e.g., how various company payrolls feed data to plans; how the various TPAs coordinate testing across plans; how money moves from the employee paychecks to the plan trusts).  The IRS hopes that after reviewing these procedures, etc., it can then use data-driven factors to surgically target a company's compliance weaknesses. 

Based on recent exam and survey activities, it seems large companies confront these types of compliance weaknesses:

• control group issues,
• deficient plan amendments,
• employees who are not collectively bargained improperly participating in a plan,
• minimum distribution failures,
• improper loan provisions,
• failure to adjust actuarially if termination is after normal retirement age,
• misclassification of employees as higher- or lower-paid,
• misclassification of employees as part-time, temporary, foreign national, independent contractor, etc.

Large companies must brace for this super-enhanced IRS audit of retirement plans.  It will be thorough and comprehensive; indeed, an IRS audit can easily last over two years.  Consider the effect on in-house counsel, HR, and payroll personnel.

Employers should not rely on the annual TPA testing or annual accountant's audit to vet out   these compliance issues.  Many of the compliance problems identified above are outside the limited engagement of the TPA's end-of-year testing or the annual accountant's audit.  Employers who sponsor retirement plans should consider performing a very compliance review to determine if tax qualification failures exist (plan document? operational? demographic?) with each of their qualified plans. 

If failures are found, companies should consider applying under the IRS compliance program to voluntarily identify and correct them, with the hope that the plan would receive an IRS letter confirming continued tax qualification.  Self-correcting and/or applying under the IRS program might postpone an IRS audit and certainly would help ameliorate any sanctions that the IRS would impose if it were the IRS instead who vetted out these compliance issues on audit.   

Why not have these employees instead contribute the $34.3 billion in vacation benefit into their retirement plan? 

I wrote about this plan design technique about 1 1/2 years ago, in my piece "How Employers Can Allow Employees to Contribute Unused Vacation Time Into a 401(k) Plan."  Sure, employers could simply allow employees to forfeit their unused vacation (and the dollar amount associated with such vacation), but if an employer chooses to allow an employee to contribute the dollar equivalent of what would have been forfeited into a 401(k) plan (and I think, reasonably, into a 403(b) plan), then the employer has that ability. . . and employees would likely view this option as a "gift" of sorts.  What they couldn't gain in a vacation, they get in retirement savings. 

Two IRS Revenue Rulings explain in more detail.  Revenue Ruling 2009-31 discusses amounts of leave that employees forfeit at year-end; Revenue Ruling 2009-32, unused leave at the time of an employee's separation from service. 

Note:  If an employer allows these types of paid time off/vacation/sick leave contributions into its retirement plan, it is likely that the employer cannot rely on a safe harbor plan.  The employer will have to test individual contribution limits. 

March 15th is a looming deadline.  If your 401(k) plan failed the ADP test, it must remove participants' excess contributions (and related earnings) by March 15th to avoid a 10% excise tax.  Similarly, if your plan failed the ACP test, same thing:  remove the excess match and after-tax contributions (and earnings) by March 15th to avoid the excise tax.  The failure to address ADP and ACP problems will likely mean that an employer will have to come out-of-pocket with an unanticipated, but required, contribution into the 401(k) plan.

In informal sessions with IRS officials in early February, the officials observed that many employers have difficulty understanding the discrimination testing data that a TPA hands back to them.  If you have concerns evaluating the information, check with your TPA for clarification.  It is not a grave error to fail a discrimination test; it is, however, typically a tax-disqualifying error not to correct. 

The IRS expects to publish the full compilation of the compliance issues revealed through the 401(k) Questionnaire this coming summer.  Templeman listed, though, the issues that seem to pervade:

• Participants obtain loans or hardship distributions, without having met the Internal Revenue Code for allowing such loans or hardship distributions;
• Companies fail to transmit employee elective deferrals timely to the plan;
• Companies fail to amend their plan documents timely and, better yet, fail to execute the documents;
• Companies do not use the proper definition of "compensation" when determining match or other allocations;
• Companies fail to include eligible employees into their plans;
• Companies do not know how to evaluate results of discrimination testing, including the ADP/ACP test (and, if there are failures, companies do not know how to resolve them).