Eligibility, Contributions, and Compensation: Three Common 401(k) Audit Findings and How to Avoid Them
Article Summary
Most 401(k) audit findings are not caused by complicated regulations. They're caused by basic plan provisions being applied inconsistently. Some of the most common issues we find involve employee eligibility, compensation definitions, and required contributions that never make it into participant accounts.
The good news is that these errors are preventable. A few simple reviews can help plan sponsors avoid correction costs, administrative headaches, and unnecessary audit findings.
When Eligible Employees Don't Get Into the Plan
A 401(k) plan document defines who is eligible to participate and when they can enter the plan. Yet one of the most common operational errors we encounter during audits is the exclusion of employees who should have been allowed to participate. We also occasionally see the opposite problem, where employees are allowed into the plan before meeting the eligibility requirements.
These mistakes often happen when payroll, human resources, and plan administration processes are not aligned. Turnover, system changes, and manual tracking can all create opportunities for employees to be overlooked.
The consequences can be expensive.
When an eligible employee misses the opportunity to make elective deferrals, the plan may have to calculate a Missed Deferral Opportunity (MDO) and fund corrective contributions. Any related employer contribution associated with the actual missed deferral amount must also be funded. In certain situations, terminated employees may not qualify for reduced corrective contribution provisions.
How to Prevent Eligibility Errors
Start with the plan document.
Review the eligibility and participation provisions regularly and confirm that your payroll and recordkeeping systems are applying those provisions correctly. Plan administrators should also periodically verify that employees are entering the plan on the dates required by the plan document.
A quick review can be significantly less costly than correcting years of missed participation.
When Payroll Uses the Wrong Definition of Compensation
Plan sponsors can at times assume compensation is straightforward. The plan document often says otherwise.
Every 401(k) plan contains a specific definition of compensation that determines how employee deferrals, matching contributions, and employer contributions are calculated. Problems arise when payroll systems use a different compensation definition than the one outlined in the plan document. This commonly occurs when certain compensation items are improperly included or excluded from plan compensation calculations.
The result can be underfunded participant accounts, incorrect employer contributions, and correction costs that extend across multiple plan years.
Unlike some operational errors that affect only a handful of participants, compensation definition errors often impact large portions of the employee population because the same payroll process is applied consistently across the organization.
How Compensation Definition Errors Are Corrected
Correction methods depend on the nature of the failure. In some situations, an operational failure may be corrected through a plan amendment that aligns the plan document with the plan's actual operation, when permitted under applicable correction guidance. Plans may also need to make corrective contributions based on excluded compensation, plus any associated lost earnings.
The longer the error exists, the more participants and plan years it can affect, making corrections more time-consuming and expensive.
How to Prevent Compensation Definition Errors
Perform annual reviews of the plan's compensation definition and ensure the individuals responsible for payroll and plan administration understand exactly how compensation should be calculated under the plan document and adoption agreement.
This review becomes especially important after payroll system changes, vendor transitions, or plan amendments. A few minutes spent validating compensation calculations each year can prevent a significant correction project later.
Auto-Enrollment Doesn't Run Itself
Automatic enrollment and automatic escalation features can improve participation rates, but they also create another area where operational mistakes occur.
We regularly see situations where automatic deferrals were not started when required or annual escalation provisions were not applied according to the plan's terms. In many cases, the systems were configured correctly when implemented but were never reviewed after payroll changes, vendor transitions, or plan amendments.
When these errors occur, plan sponsors may be required to fund employer contributions associated with the participant's actual Missed Deferral Opportunity. SECURE 2.0 also introduced certain correction relief provisions, including rules affecting terminated employees beginning in 2024.
How to Prevent Auto-Enrollment Errors
Automatic features should never be considered a set-it-and-forget-it process.
Establish processes and controls to ensure auto-deferrals and auto-escalations operate according to the plan's provisions and applicable requirements. Testing a sample of participants throughout the year can help identify errors before they become widespread correction projects.
Small Administrative Errors Become Large Correction Projects
Eligibility failures, compensation calculation mistakes, and auto-enrollment errors often begin with a single employee or payroll cycle. Left unchecked, they can affect dozens of participants, multiple plan years, and substantial employer contributions.
The plans that avoid these issues are usually not the ones with the most sophisticated systems. They're the plans with clear processes, periodic reviews, and a strong understanding of what the plan document actually requires.
Where compliance ends, good plan administration begins.
FAQ
What is a missed deferral opportunity (MDO)? A missed deferral opportunity occurs when an employee who should have been allowed to make 401(k) deferrals was not given that opportunity. Correction methods often require the calculation of the missed deferral amount and related corrective contributions.
What happens if an eligible employee is excluded from a 401(k) plan? The plan sponsor may need to make corrective contributions on behalf of the employee and fund any employer contribution associated with the actual missed deferral amount. The required correction depends on the specific facts and circumstances.
What is a compensation definition error in a 401(k) plan? A compensation definition error occurs when employee or employer contributions are calculated using compensation that does not match the definition contained in the plan document. These errors can affect deferrals, matching contributions, and profit-sharing contributions. Correction may require additional contributions and lost earnings contributions.
Why do compensation definition errors occur? Most compensation errors stem from misunderstandings of the plan document, payroll system setup issues, or changes in payroll processes that are never reconciled back to the plan's compensation definition. Regular reviews can help identify problems before they affect multiple plan years.
Why do auto-enrollment errors occur? Auto-enrollment failures frequently result from payroll system issues, administrative oversights, or plan provisions that are not being consistently monitored after implementation. Establishing controls and periodic reviews can help identify problems early.
Are auto-enrollment and auto-escalation errors correctable? Yes. Correction methods are available, but they can require additional calculations and plan sponsor contributions. Addressing issues promptly generally limits correction costs and administrative burden.
What's the best way to reduce common 401(k) operational errors? Start with the plan document. Regularly review employee eligibility, compensation definitions, and automatic enrollment provisions. Then confirm that payroll and administrative processes are operating exactly as the plan requires. Most audit findings arise when written provisions and day-to-day operations drift apart.
For additional guidance, please contact the Larson 401k Audit Team.
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