The Payroll File That Doesn't Match the Census
During annual testing for a 401(k) plan, you reconcile the payroll file to the census and find three problems: (1) two employees who became eligible mid-year were not enrolled and made no deferrals, though they would have deferred had they been given the chance; (2) one participant's compensation in the census omits a $12,000 bonus that was paid and should be included under the plan's compensation definition; and (3) the employer deposited deferrals for the fourth quarter on January 30, though payroll ran biweekly and the amounts were withheld throughout the quarter. The plan has a 6% match and is not a safe harbor plan. The plan sponsor is a 60-employee professional services firm and wants to know 'how bad this is' before the testing deadline.
1. For each of the three issues, identify the type of failure and the general correction approach.
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- Missed deferral opportunity (eligible employees not enrolled). This is an operational failure. Correction generally requires making a corrective employer contribution to the affected participants' accounts equal to a percentage of what they would have deferred (commonly 50% of the missed deferral, using an estimated rate), plus any missed match, plus earnings. Because these are NHCEs, self-correction may be available if the error is corrected timely and the plan meets the applicable conditions; otherwise VCP.
- Compensation error (omitted $12,000 bonus). If the plan's compensation definition includes bonuses, the participant's deferrals and match were computed on too little pay. Correction: recalculate deferrals and match on the correct compensation, make the employer contribution for the missed match, and address any deferral shortfall (the participant may owe the deferral amount, or the employer may fund it depending on the correction method). This also affects testing because compensation feeds ADP/ACP and 415.
- Late deposit of deferrals. Participant deferrals are plan assets once withheld and must be deposited as soon as administratively feasible - for a small plan, generally no later than the 7th business day after withholding under the DOL safe harbor. Depositing Q4 amounts on January 30 is a late deposit. Correction requires depositing the amounts plus lost earnings (computed under a DOL-acceptable method) and filing Form 5330 for the prohibited transaction excise tax if applicable.
2. The sponsor asks whether it can use self-correction for all three. What determines eligibility, and which issue is most likely to require VCP?
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Self-correction (SCP) eligibility depends on:
- The failure being insignificant (for certain failures) or meeting the specific safe-harbor correction standards;
- Timeliness - corrected within the applicable correction window (generally before the IRS finds it, and often within a defined period);
- Established practices and procedures in place; and
- The failure not being egregious or part of a pattern.
The late deposit is the most likely to draw scrutiny and may require VCP if the amounts were significant or the delay was long, because late deposits are also prohibited transactions (use of plan assets) requiring excise tax reporting and lost-earnings restoration. Missed deferrals for multiple employees can also push the failure from insignificant to significant, making VCP the safer route.
Practical answer: self-correct the compensation/match error if it qualifies, but evaluate the missed-deferral and late-deposit failures against the significance and timeliness standards - and if the aggregate is significant, file VCP. Document the analysis either way.
3. The sponsor wants to know the downstream effect on testing. Which of the three issues changes the ADP/ACP results, and how?
Read the worked answer
All three can affect testing, but the compensation error has the most direct effect:
- Compensation error: Correcting the $12,000 bonus increases that participant's compensation, which lowers the deferral rate (deferrals ÷ higher comp) and changes the match calculation. If the participant is an HCE, a lower HCE deferral rate helps ADP; if an NHCE, it can lower the NHCE average and hurt the HCE ceiling. The corrected match also changes ACP.
- Missed deferrals: Adding corrective contributions for the two NHCEs increases NHCE deferrals (and match), which generally improves the ADP/ACP results - a silver lining, but only if the correction is properly reflected in testing.
- Late deposit: Does not change the deferral amount for testing (the deferrals were made), but it is a fiduciary/prohibited-transaction issue, not an ADP/ACP input.
Key step: rerun testing on corrected data before concluding anything about refunds. Testing on the flawed census will produce wrong results and potentially unnecessary refunds or missed corrections.