TOP 10 401(K) ERRORS AND HOW THE IRS WANTS YOU TO FIX THEM

1. TOP 10 401(K) ERRORS ANDHOW THE IRS WANTS YOU TO FIX THEM May 29, 2009 James R. Griffin Jackson Walker L.L.P. 901 Main Street, Suite 6000 Dallas, Texas 75202 jgriffin@jw.com • 214.953.5827

2. Legal Requirement and Reality of Errors 401(k) Plans must be tax-qualified: In Form In Operation

3. Adverse Consequences of Disqualification Tax penalties Litigation by participants Violate loan covenants Lose creditor protection Impermissible plan investments Violate Federal securities laws Withhold audit report for Form 5500

4. Highlights of E.P.C.R.S.Revenue Ruling 2008-50www.irs.gov Correction Principles Categories of Qualification Failures Specific Programs

5. Correction Principles Full Correction—All Years Restore All Benefits Reasonable and Appropriate

6. Categories of Qualification Failures Plan Document Failure Operational Failure Demographic Failure Employer Eligibility Falure

7. Specific Programs Self-Correction Program—SCP Voluntary Correction With Service Approval—VCP Audit Closing Agreement Program—Audit Cap

8. Self-Correction Program—SCPInsignificant Failures No reporting to IRS No penalty Available during IRS audit No deadline Established practices and procedures (formal or informal) reasonably designed to promote and facilitate overall plan compliance Not available for egregious failures

9. Self-Correction Program—SCPSignificant Failures No reporting to IRS No penalty Not available during IRS audit Must be corrected with 2 years after the plan year in which the failure occurred Established practices and procedures (formal or informal) reasonably designed to promote and facilitate overall plan compliance Not available for egregious failures Plan must have determination letter or opinion letter

10. Voluntary Correction With Service Approval—VCP Filing with IRS is required Payment of fee is required Not available if plan is under examination Available for late amendments

11. VCP User Fee

12. Audit Closing Agreement Program—Audit Cap Applies to errors discovered during audit. Sanction is negotiated percentage of Maximum Payment Amount (MPA). MPA is a monetary amount equal to the tax IRS could collect upon disqualification. Sum of the following for all open tax years:

13. Maximum Payment Amount Tax on the trust (Form 1041) Additional employer income tax resulting from the loss of plan contribution deductions Additional participant income tax resulting from early taxability of plan accounts, even if not distributed or rolled over. Any other tax or penalties.

14. #1.Failure to Timely Adopt Interim Amendments

15. EGTRRA Minimum required distributions Final regulations for 401(k), 401(m) and 415 Mandatory cashout Examplesof Interim Amendments

16. Adopt all missing amendments Make VCP filing--$375 filing fee covers all missing amendments Adopt prototype plan Track IRS amendment requirements Retirement News for Employers What You Need to Do

17. #2.Failure to Follow the Plan’s Definition of Compensation for Determining Contributions

18. #3Failure to Include Eligible Employees in the Plan or the Failure to Exclude Ineligible Employees from the Plan

19. Compensation to participant for lost deferral opportunity Windfall to participants 50% instead of 100% 40% for after tax contributions Based on actual election or ADP Plus full matching contribution Adjusted for investment earnings or losses Characteristics of this Error

20. Amy’s elective deferral election at the start of 2008 somehow was never processed by the employer’s payroll system. As a result, Amy received taxable compensation that should have been contributed to the plan during the first six months of the year. The plan’s ADP for NHCEs was 5%. Amy’s elected to defer 10% of pay. Amy earned $20,000 for the six months that no deferrals were made.

21. Amy’s missed deferral amount is $2,000 (i.e., 10% (Amy’s election percentage) multiplied by $20,000 (her compensation earned during the period in which her employer failed to implement her election)). The amount of the corrective contribution the employer must make on Amy’s behalf is $1,000 (i.e., 50% multiplied by Amy’s $2,000 missed deferral amount). 

22. Bob elected to defer 5% of his compensation in 2008. The plan includes bonuses in the definition of compensation that is used for an employee making elective contributions. Although Bob was able to make deferrals on his base compensation, the payroll system overlooked his bonus. The ADP was 3%, and Bob’s base compensation was $19,000, and his bonus was $2,000.

23. Bob’s missed deferral amount is $100 (i.e., 5% (Bob’s election percentage) multiplied by $2,000 (his 2008 bonus from which elective contributions were not made even though he elected to make a contribution of 5% of all compensation, which included bonuses)). The corrective contribution required on behalf of Bob is $50 (i.e., 50% multiplied by his $100 missed deferral).

24. A NHCE has compensation of $40,000 and is incorrectly excluded for a full year from a plan that provides a match equal to 100 percent of the first 3 percent of compensation.  The plan has a NHCE ADP equal to 5 percent. The QNEC for lost opportunity cost to make deferrals is $1,000 ($40,000 x 5% x 50%).  The QNEC for the matching contribution is $1,200 ($40,000 x 3%).

25. #4.Failure to Satisfy Loan Provisions

26. Loans that exceed maximum dollar amount Loans with non-compliant payment schedules Defaulted loans Ways to Mess Up Plan Loans

27. On June 1, 2007, Jane took a $10,000 loan from her employer’s 401(k) plan. The interest rate on the loan was 8%. Her loan was for a five-year period and required monthly payments of $203. Her loan payment was to be made by payroll withholding. The plan did not provide for a “cure period” for missed installments. Paychecks are issued at the beginning of the month. Jane’s loan information was not forwarded to the payroll department and, as a result, no payments were withheld in 2007. The problem was discovered on December 15, 2007, during an annual review of the plan’s records. July 1, 2007 is considered to be the first missed payment, and her outstanding loan balance of $10,067 (loan plus accrued interest) is treated as a deemed distribution. Jane is required to report $10,067 in income on her 2007 Form 1040.

28. #5.Impermissible In-Service Withdrawals

29. George is the 100% owner of the George Company. The company sponsors a 401(k) plan which provides that a participant may take a distribution on account of hardship. • Hardship withdrawals are available for the safe harbor reasons. • The plan requires that the participant use all other sources of financing including proceeds from insurance, liquidation of other assets, and loans from other commercial sources before applying for a hardship distribution. • Jim, a plan participant, asked for and received a hardship distribution of $20,000 from the plan. He did not provide a reason for the distribution and did not establish that he had used other sources of financing before applying for the hardship distribution.

30. The company should take reasonable steps to ensure that Jim returns the erroneously distributed amounts to the plan. Jim should also be advised that to the extent any amounts are not returned, they are not eligible for tax favored treatment (i.e., the amounts are not eligible for rollover to an IRA or other retirement plan). In addition, the plan’s administrative procedures should be revised to ensure that the error does not occur again.

31. #6.Failure to Satisfy IRC 401(a)(9) Minimum Distribution Rules

32. #7.Employer Eligibility Failure

33. #8.Failure to Pass the ADP/ACP Nondiscrimination Tests under IRC 401(k) and 401(m)

34. Incorrectly classifying employees as HCE or NHCE Using an incorrect definition of compensation in the tests Calculating the test incorrectly Just not getting it done How Can This Error Happen?

35. A calendar year plan with a 401(k) arrangement fails the ADP test for the plan year ending 12/31/07. The statutory correction period is the 12-month period from 01/01/08 to 12/31/08. The self-correction period under SCP runs from 01/01/09 to 12/31/10. After this date (unless the violation is considered insignificant), VCP must be used to correct the violation.

36. QNECs 1 to 1 correction method No-disaggregation Correction Methods After Last Day of Statutory Testing Year

37. #9.Failure to Properly Provide the Minimum Top-Heavy Contribution under IRC 416 to Non-Key Employees

38. If the participant is a key employee at any time during the previous plan year, the person is considered a key employee for the entire year. If the key employee account balances exceed 60%, the plan is TH. No 1,000 hour requirement for a TH allocation. TH minimum contribution is based on a total compensation definition. Elective deferrals made by a non-key EE to a 401(k) plan cannot be considered for the TH minimum contribution. How Can This Error Happen?

39. #10.Failure to Satisfy the Limits of IRC 415

40. In 2007, John earned $100,000 in compensation as an employee of the QP Corporation and was a participant in QP Corporation’s 401(k) Plan. The plan permits elective contributions and provides a 100% matching employer contribution for the first $8,000 in elective contributions, as well as discretionary profit-sharing contributions. The plan does not allow an employee to designate any portion of his or her elective contribution as a Roth contribution. QP did not allocate any forfeitures to participants in 2007. During 2007, QP made contributions totaling $58,000 for John consisting of: • elective contributions: $15,000 • employer matching contributions: $8,000 • employer profit-sharing contributions: $35,000 • The 2007 contribution limit for John is $45,000 (the lesser of $45,000 or 100% of John’s $100,000 compensation). Accordingly, the $58,000 contributions made for John in 2007 exceeded the limitation under §415(c) by $13,000. • QP discovered the failure to limit the contributions for John in early 2009.

41. The correction of the excess contribution of $13,000 for John would be as follows: • Step 1: John made $7,000 in unmatched elective contributions (elective contributions of $15,000 less $8,000 that QP matched). The plan must distribute the $7,000 (adjusted for earnings) to John. After the distribution, there is still an excess contribution of $6,000 that the plan must correct, to the extent possible, under Step 2. • Step 2:  John made $8,000 in matched elective contributions. The plan must distribute $3,000 in matched elective contributions (adjusted for earnings) and forfeit the corresponding matching contribution of $3,000 (adjusted for earnings). This step fully corrects John’s remaining $6,000 excess. • As a result, John will receive a total distribution of $10,000 (adjusted for earnings). John must include the entire corrective distribution in his income. However, John will not have to pay the additional 10% tax on early distributions under §72(t) of the Code. The distribution is not eligible for rollover to another qualified plan or an IRA. In addition, the plan will forfeit $3,000 (adjusted for earnings) from John’s matching contribution account. This amount will be transferred to an unallocated account and used to reduce employer contributions required for the current year and if applicable, subsequent year(s).

42. BonusFailure to Provide a Safe Harbor 401(k) Plan Notice

43. Rainbow Company established a safe harbor 401(k) plan in 2005. The plan provides for matching contributions in an amount equal to: 100% of elective contributions up to 3% of the employee’s compensation plus 50% of elective contributions greater than 3%, but not more than 5% of the employee’s compensation. Eligible employees received timely notices in 2004, 2005, and 2006. However, in 2007 Rainbow failed to provide safe harbor notice to its employees. In addition, Rainbow did not furnish notices to employees who became eligible to participate in the plan in 2008. Rainbow discovered the problem when it conducted an internal review of its plan operations at the end of 2008.

44. Violet first became eligible to participate in the plan on January 1, 2008. She did not receive notice and Rainbow did not inform her of her right to make elective contributions to the plan. She earned $20,000 in compensation in 2008.

45. Indigo has been a participant in the plan since 2005. She has made elective contributions of 2% of compensation each year, after receiving notices in 2004, 2005, and 2006. While she did not receive a notice in 2007, the human resource department (HR) informed her that the employer’s matching contribution formula will remain the same for 2008 and that she should inform HR if she wanted to make any changes to her elective contributions for 2008.

46. Exclusion of an eligible employee. • Violet belongs in this category. • Due to its failure to provide notice, Rainbow did not inform Violet of her ability to make an elective contribution when she was eligible. To correct the failure, Rainbow must make a corrective contribution for Violet to replace her missed deferral opportunity and the missed matching contributions that occurred because Rainbow improperly excluded her from the plan.

47. Fixing an administrative problem. • Indigo belongs in this category. • The failure to provide notice did not prevent her from making an informed timely election to change (or maintain) her elective contribution to the plan. No corrective contribution for Indigo is required. The plan needs to reform its procedures to ensure that she receives timely notices in the future.

48. TOP 10 401(K) ERRORS ANDHOW THE IRS WANTS YOU TO FIX THEM May 29, 2009 James R. Griffin Jackson Walker L.L.P. 901 Main Street, Suite 6000 Dallas, Texas 75202 jgriffin@jw.com • 214.953.5827