Top 10 Operational Failures with 401(k) and 403 (b) Plans

When acting as the plan administrator for 401(k) and 403(b) plans, avoiding operational errors is paramount. While some errors may seem innocuous at first glance, seemingly simple operational failings can have significant repercussions for both plan sponsors and participants. 

These errors include everything from inaccurate contribution calculations to failures in compliance and testing. They may be committed by the plan administrator or by third-party service providers. Each error may result in corrective actions and fines and even jeopardize the plan’s tax-qualified status. In addition to regulatory compliance issues, failing to adequately manage a plan can also have a significant impact on the participants’ financial well-being.

Below, we’ll explore the top ten operational errors that may occur, their implications, and the steps that plan administrators can take to mitigate or prevent them.

This list is arranged in order of importance: the most significant errors are contained at the end of this article, while less significant failures are discussed first.

10. Failure To Timely Amend the Plan for Legislative Changes

The laws and regulations governing 401(k) and 403(b) plans change periodically. These changes are generally initiated by federal legislation, regulatory agencies such as the IRS or the Department of Labor, and state legislatures. They can impact contribution limits, eligibility criteria, investment options, distributions, and compliance requirements.

Plan administrators are responsible for monitoring these changes, communicating them, and taking corrective action before the new legislation goes into effect. 

For example, the SECURE Act 2.0 brought a variety of changes related to employer-sponsored retirement plans, aimed at making it easier for participants to save. Some resulting changes have already gone into effect, while others go into effect on varying effective dates through 2027. As plan administrators evaluate new legislation and changes to plan provisions, consult with your retirement plan advisor, recordkeeper, third-party administrator (TPA), or ERISA attorney about changes that need to be made to your plan to remain in compliance with all regulatory requirements.

9. Failure To Correct Failed ADP/ACP Nondiscrimination Tests in a Timely Manner

The IRS requires the Actual Deferral Percentage (ADP) and/or Actual Contribution Percentage (ACP) nondiscrimination tests to ensure that 401(k) and 403(b) plans do not disproportionately benefit highly compensated employees (HCEs) compared to non-highly compensated employees (NHCEs).

Common errors surrounding ADP/ACP tests include:

• Not performing the tests on time 
• Not making corrective qualified non-elective contributions (QNECs) or doing so incorrectly
• Refunds of excess contributions not returned in time
• Failing to follow testing procedures as specified in the plan document terms (e.g. defining contributions incorrectly or applying or not applying the top-paid group election per the plan terms)

To prevent these errors, consult a retirement plan advisor, recordkeeper, or third-party administrator (TPA) for proper corrective actions as well as preventative measures that can be taken. 

8. Failure To Apply Forfeitures In a Timely and Correct Manner

A forfeiture is when a plan participant loses some or all of their plan account benefits, typically because they left their employer before they became fully vested in their account balance. The plan document outlines vesting provisions and how these forfeitures may be used. 

In most cases, forfeitures can be used to pay plan expenses or reduce employer contributions in the year of the forfeiture. However, they can also be reallocated to plan participants. 

Common forfeiture errors include: 

• Allowing forfeiture balances to accumulate over more than one year
• Using forfeitures for a purpose not specified in the plan document
• Distributing forfeitures back to the plan sponsor

To correct this issue, administrators must return the plan to the position it would have been had the error not happened. Other prohibited transaction issues may arise as a result. 

7. Failure To Follow Participant Loan Rules

Participant loan rules are the conditions under which participants may borrow money from their own retirement accounts. These rules stipulate loan eligibility (including eligible purposes), repayment terms, loan limits and tax implications. Organizations should review participant loans on a monthly basis to ensure proper authorization, compliance with plan provisions, and timely repayment. 

Common errors include:

• Failure to set up payroll to collect loan repayments
• Collecting excess loan repayments after the loan has been repaid

If loan repayments were set up late in payroll, the loan may need to be re-amortized based on the lateness of the loan repayments. If loan repayments were never set up, the loan would default. In that case, the participant would be taxed on the loan in the year the default occurred. 

If repayments were collected over and above the loan amount, the excess should be returned to the participant. 

6. Failure To Issue Required Minimum Distributions (RMDs)

Required Minimum Distributions (RMDs) are the minimum amounts that account holders, typically those with tax-deferred retirement accounts like Traditional IRAs, SEP IRAs, SIMPLE IRAs, 401(k), and 403(b)  plans, must withdraw from their accounts each year once they reach a certain age.

As of January 1, 2023, the minimum RMD age was raised to 73. 

When it comes to RMDs, recordkeepers and plan administrators are usually only responsible for reminding participants that they should take their required withdrawals. The participant is responsible for actually taking the withdrawals. 

For participants with more than one 403(b) account, the RMDs for each account may be calculated separately. However, participants are only required to take the total RMD from some accounts rather than all of them, and recordkeepers are rarely responsible for verifying that participants did this correctly. As a result, participants sometimes don’t withdraw enough to satisfy the requirements.

If RMDs are not taken or are insufficient, the IRS may issue an excise tax of 50% on the required distribution amount in penalty. Under the SECURE 2.0 Act, the penalty drops to 25% and possibly 10% if the RMD is corrected within two years. 

If the taxpayer can show that the failure was for a good reason and that steps are being taken to correct it, the IRS sometimes waives the penalty.

Another potential adverse result is plan qualification failure, the consequences of which vary depending on the severity. 

To correct an RMD issuance failure, use the Voluntary Correction Program (VCP) to waive the participant penalty and preserve plan qualification. To prevent the issue on an ongoing basis, review birthdates on your census, note those approaching RMD, and follow up with your TPA and plan participants. 

5. Failure To Properly Administer Automatic Enrollment

The SECURE Act 2.0 includes a provision requiring that employers offering 401(k) and 403(b) plans automatically enroll participants. This provision impacts any newly established plans starting on or after January 1, 2025. 

In this scenario, the best practice is to avoid issues by obtaining proof of opt-out from all employees who do not want to enroll. 

Common errors relating to auto-enrollment include: 

• Failing to enroll new employees who meet eligibility requirements
• Not enrolling eligible employees in a timely manner
• Auto-escalation issues, such as failing to auto-escalate contributions or auto-escalating beyond 15% 

Corrective actions vary depending on when the failure is found and resolved. It may include compensating 100% of employer contributions and lost earnings. It could also include 25% or 50% of missed deferrals if not corrected promptly.

Usually, your recordkeeper or TPA are responsible for enrollment, so to prevent this issue, actively monitor reports from your plan providers and compare them to your payroll reports. 

4. Failure To Follow the Plan’s Eligibility Requirements

Eligibility requirements define which employees can enroll in a retirement plan and make contributions. Examples of situations in which eligibility requirements were not followed include: 

• Designating eligible employees ineligible, often due to administrative errors, misinterpretation of plan provisions, or failure to identify eligibility
• Failure to enroll eligible employees, failure to enroll them on time, or enrolling them too early

These issues are often caused by an improper understanding of the plan’s eligibility requirements, a lack of clarity over responsibilities between the service provider and plan sponsor, rehiring previous employees, and having incorrect census data.

If the plan’s eligibility requirements were not followed, corrective action includes making a corrective contribution to compensate the employee for the missed deferral opportunity and 100% of the missed employer match opportunity.

To prevent such issues, establish and consistently follow procedures for identifying and contacting eligible employees. Notify employees of their eligibility annually (if not more often). Finally, TPA reports should be reviewed frequently and reconciled with Plan Sponsor data.

3. Failure To Properly Calculate Employee Elective Deferrals

Elective deferrals refer to the portion of an employee’s compensation they choose to contribute to their retirement plan. Depending on the type of plan, these contributions may be pre- or post-tax.

Elective deferrals must be made according to participant elections and aligned with the terms in the plan document.

Common elective deferral errors include: 

• Not entering deferral percentages into the payroll system correctly or on time
• Incorrectly classifying pre-tax, after-tax, and Roth IRA elective deferrals
• Discrepancies between the recordkeeper and payroll that may create doubt as to what was the true desired election of the employee

Corrective actions vary depending on the error. If deferrals are too high, distribute the excess to the participant. If the issue was under-contribution, make a corrective contribution for the affected participant. In all cases, adjust for calculated earnings: the amount that would have been earned in investment income during the missed period had the error never occurred. 

Prevent this issue by monitoring changes in elective deferrals through the recordkeeper website and reconciling elective deferrals between the recordkeeper and payroll. Additionally, discuss opportunities to implement 360 integration between systems with your recordkeeper and payroll provider to eliminate manual processes and reduce the possibility of mistakes.

2. Failure To Use the Correct Definition of Plan Compensation

Plan compensation refers to the types of compensation considered eligible for contribution within an employer-sponsored retirement plan. The specifics vary by plan and are spelled out in the plan document. This definition is critical for accurately calculating participant deferrals and employer contributions and is used in ADP/ACP testing. 

Common errors include: 

• Using the same definition for all contribution types (plans may have unique definitions for employer vs. employee elective deferrals) 
• Including or excluding certain types of compensation in contrast to the plan’s definition, such as:
  • Bonuses, overtime or commission
  • Fringe benefits or stipends (e.g., cash rewards, car allowances, or taxable group term life insurance policies)
  • Compensation paid after severance from employment

Corrective action varies by error. For example, if deferrals were too high, distribute the excess to the employee. If the error resulted in excess employer matching or profit sharing, forfeit the excess. If the error resulted in under-contribution, then make a corrective contribution. In all cases, adjust for calculated earnings. 

To prevent these issues, verify payroll for proper wage coding and monitor payroll conversions and upgrades. Additionally, consider the definition of compensation impact whenever you change recordkeepers or amend the Plan. 

1. Failure To Remit Deferrals in a Timely Manner 

Coming in at Number 1, and the most important operational failure with 401(k) and 403(b) plans, is the failure to remit deferrals in a timely manner. 

Employees’ elective contributions should be deposited in their retirement accounts at the “earliest date contributions can reasonably be segregated from the employer’s general assets.” This typically means as soon as the employer can set money aside specifically for retirement contributions. For example, if the plan sponsor can remit payroll taxes within 1 to 3 business days of running payroll, then employee contributions and loan repayments should also be remitted to the plan within 1 to 3 business days.

This applies to both elective deferrals and loan repayments. 

Failure to remit these funds within the appropriate timeframe would result in a prohibited transaction by the IRS and the Department of Labor because the plan sponsor is using plan assets.

Correcting this issue includes depositing missed deferrals and lost earnings, possibly paying an excise tax, and filing under the Voluntary Fiduciary Compliance Program. To prevent these issues, a remittance policy should be established and implemented. Additionally, manual processes should be eliminated, and a schedule of remittances should be used, reconciling payroll to the trust as soon as possible. 

Finally, spot-check a sample of participants each payroll and reconcile the following to the plan: 

• Deferrals and loan repayments
• Total transfer to trust
• Individual allocation of investments

Smith + Howard: Reliable Benefit Plan Auditors

Administering retirement plans requires careful oversight and attention to detail. Failure to do so could negatively impact participants’ finances, incur penalties, and even risk the plan’s tax-qualified status – all errors that plan administrators should strive to avoid.

Working with a trusted benefit plan auditor can help you uncover or avoid these errors and stay current on regulatory and compliance developments that may impact your plan requirements. 

Smith + Howard’s nationally accredited employee benefit plan audit specialists are focused solely on benefit plan audits year-round and serve hundreds of benefit plan clients. We can help your business navigate these complex requirements. Our professionals will perform your audit efficiently and provide you with the confidence that your plan complies with all applicable laws and regulations. 

To learn more about how Smith + Howard can help you navigate the complexities of managing employee benefit plans, contact an advisor today.