When 401(k) plans go bad: avoiding disqualification

By Maha Ahmed, Azzad qualified plan financial consultant

Business owners who sponsor 401(k) plans understand the favorable tax benefits these plans can provide. But the benefits come at a cost. Employers must follow strict Internal Revenue Service (IRS) and Department of Labor rules. Those who don’t can find themselves in hot water.

A 401(k) plan is said to be “qualified” when it complies with tax rules and is therefore entitled to its favorable tax status. But plans that run afoul of the rules (for example, by improperly excluding participants, missing contributions, or failing discrimination tests) can become “disqualified.” The potential tax effects of plan disqualification are severe. These include having to pay taxes on contributions and earnings you thought were tax-free or even tax-deductible and even losing the ability to roll over plan assets.

Even worse, a plan may be disqualified retroactively if the plan defect occurred in a prior year. This means you would likely need to file amended returns to reflect the tax effects of disqualification for those prior years. Penalties for under reporting income in those prior years could also be imposed. And while the IRS generally can’t go back more than three years (six years if there was a substantial under reporting of income) to collect taxes for any earlier year, the IRS might require correction of those closed years if an employer seeks to re-qualify its plan.

Luckily, the IRS has adopted several programs that may help you avoid the potentially disastrous consequences of disqualification.

The Self-Correction Program (SCP) allows you to self-correct many plan errors and preserve the tax-favored status of your plan without contacting the IRS or paying a fee. “Correction” means that the plan and participants must be placed in the same position they would have been if the failure had not occurred. The program is available for any errors that occur when you don’t follow your plan’s written terms.

If you’re not eligible for SCP, the next step is the Voluntary Correction Program (VCP). This program is available only if your plan is not being audited. You submit an application to the IRS describing the plan failure(s), how you intend to correct those failures, and administrative changes you will adopt to avoid such failures in the future. You also pay a fee ranging from a few hundred dollars to $25,000, depending on the nature of the failure and the number of plan participants. If your application is approved, the IRS will agree not to disqualify your plan because of the disclosed failures if you complete the corrections within 150 days.

If the IRS discovers the failures itself (for example, during an audit), you may still be able to preserve your plan’s tax benefits by using the Audit Closing Agreement Program (Audit CAP). Under this program, you must correct the plan failures, enter into a “closing agreement” with the IRS, and pay a penalty equal to a negotiated percentage of the additional taxes that would’ve been payable had the plan been disqualified.

Of course, it’s best you avoid disqualification in the first place. Keep in mind: you can correct insignificant errors at any time. And you can even self-correct significant operational errors if you act promptly. Contact us if you have any questions about your responsibilities or suspect you may have an error in your plan.

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