Depending on the severity and magnitude of the correction, it may be necessary to involve legal counsel to make a submission into one of the IRS’s corrective programs.
Following is a list of the payroll-related matters most commonly identified in the course of a 401(k) plan audit:
- Eligible compensation per the plan document is not initially coded correctly in the payroll system. When the 401(k) plan is initially set up, or during a payroll conversion, it is important to verify that the correct compensation (as per the plan document) has been coded into the payroll system. This will prevent errors in the definition of compensation upon which future contributions into the plan are based.
- Eligible compensation per plan document is not properly/timely updated in the payroll system to reflect plan amendments. This is critical if an amendment is going to change a parameter of eligible compensation. For example, if the plan is now including earnings from bonuses as eligible compensation, but has historically not done so, then it is necessary to update your systems.
- Eligible compensation codes within the payroll system are not reviewed or recalculated by management for accuracy. Review the listing of codes, as there could be a longstanding miscoding that no one has realized since the initial coding.
- In connection with mergers or acquisitions, eligible compensation codes for the merged/acquired employees are not properly entered into the payroll system. With the flurry of activity, this can often be overlooked or miscoded. Eligible compensation coding for the new employees should conform to the definition of compensation as per the plan document or by amendment to the plan document.
- Caps on deferrals are not properly set up in payroll system. Verify that the caps have indeed been implemented for each potential participant in the plan. There have been instances in which a certain department or group of employees has not been set up properly and exceeded the cap.
- Pay rates are not properly updated in payroll system. A procedure should be in place for a supervisor to review the pay rates within the system after personnel responsible for making the updates have completed the inputs. Obtain evidence of the review through sign-off of the spreadsheet or personnel action form.
- Catch-up contributions (as dictated by the plan document) are improperly excluded or included within payroll system. Depending on the parameters of your plan, it is important to verify that contributions in excess of Internal Revenue Code (IRC) limits for participants age 50 and older have been properly coded within the payroll system to allow or disallow for catch-up contributions.
- Highly Compensated Employee’s (HCE) annual compensation limit is not properly capped within payroll system for deferral withholdings. Each year, the IRS can update the maximum annual compensation for which contributions may be made under a qualified plan. If the plan does not have a cap in place, there is the potential for contributions to exceed IRC limits.
- For payroll systems that calculate employer contributions, employer match improperly includes/excludes catch-up contributions in payroll system. If the plan document allows matching, verify that your payroll system is properly set up for this parameter to ensure the match includes or excludes the catch-up contributions.
- Deferral percentage or flat rate not updated per participant request within payroll system. This often occurs when there is a breakdown in the communication or personnel performing the updates. It is a best practice to have more than one person available to make updates within payroll in a timely manner. The unexpected absence or a vacation of the primary person who performs this function can cause errors that may not be discovered until much later.
- Repayment of participant loans is not properly tracked in the payroll system/deducted from the loan balance. Loan repayments have a payment schedule and must be repaid within IRC time limits or the loan may need to be re-amortized to ensure that it is repaid within the regulatory guidelines. There is also the potential for a new loan to go unnoticed and no payments to begin. Procedures should be in place to ensure the plan sponsor is properly notified of new loans to set up for repayments by the plan’s record keeper.
Perform a self-review of your 401(k) plan and consider the payroll-related matters most commonly identified in the course of a 401(k) audit. Evaluate whether your plan has the controls in place to minimize any internal-control risks and, if not, contact your 401(k) auditor or plan consultant for assistance.
Sandy P. Purdy, CPA, is a senior manager in Lindquist LLP’s San Ramon office. She has spent more than 14 years in public accounting, working with employee benefit plans of various sizes, complexities and structures. She performs both full and limited-scope audits of more than 25 defined contribution and defined benefit plans with more than $400 million in total assets.
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