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Avoiding Pitfalls of 401(k) Plans

BOSTON-As retirement plan sponsors navigate the rules and regulations of the Internal Revenue Service and Department of Labor they'll be looking to their service providers for help. And those service providers better have answers, according to a panel presentation at the National Investment Company Service Association's recent East Coast Regional Meeting.

"It is incumbent upon the service provider to know the law and communicate it to their clients and to assist them," said Mary W. Rosen, associate regional director for Boston of the Employee Benefits Security Administration, a division of the DOL.

"A plan only operates as well as its weakest link," said Wayne R. Kamenitz, executive director of the performance and reward practice at Ernst & Young. And if one of those links compromises the strength of the plan's chain of operations, not only the sponsor, but also their service providers could be exposed to liability, he said. "It's important to identify these problems before the IRS finds them. It's a game of beat the clock," Kamenitz said.

IRS examiners target "pockets of non-compliance," said Betty McClernan, acting director of employer plan examinations for the IRS.

"If you find problems in key areas, you're likely to find problems elsewhere," she said. And agents are required to expand exams as broadly as necessary, she added.

To avoid ugly encounters with the IRS and DOL, Kamenitz recommended service providers and plan sponsors adopt a risk-based approach that mirrors the ones those agencies use. Kamenitz enumerated common plan pitfalls for sponsors and their service providers alike to consider.

For example, companies that reduce their staff must be aware of vesting and distribution, Kamenitz said. Employees who have vested must be treated as such according to plan documents, and all disbursements must be timely.

Another common problem occurs when companies merge or are acquired. Plan sponsors and their service providers must be careful to ensure that employees' records accurately reflect their starting date and that new employees are immediately enrolled in profit sharing or other retirement-related benefits. If the terms of an acquisition call for the acquired company's retirement plan to be dissolved, distributions must be done properly and swiftly.

Employees who are added to staff as a result of the acquisition must be made aware of the terms of the new retirement plan, and how their prior service will be counted, if at all.

Plan documents are another major concern. They must be issued promptly and circulated appropriately to employees. The IRS and DOL also typically check whether all plan amendments are delineated in the documentation, Kamenitz said.

Plan sponsors and their service providers should also double check deferral percentages. If those are calculated by a third party, without employer intervention, plans runs a higher risk of incorrect calculations. Service providers must make sure also that the data they are provided is correct.

The definition of compensation causes problems in between 50% and 60% of all 401(k) exams, Kamenitz said. "It's easy to look at a plan and not see the definition of compensation," he said. If an employee exercises stock options, for example, the profits should be reflected in the employee's W-2 tax form as a type of income. Because it is income, it should also be included when calculating the employee's plan deferral.

Likewise, incorrectly calculated compensation can cause employers to inadvertently exceed the IRS-set compensation ceilings, thereby allowing employees to participate illegally.

For its part, the DOL is especially interested in ensuring deferred amounts and employer matches are applied to employees' accounts "as soon as reasonably segregable," Rosen said. Since 1998, the DOL has won $380 million in restitution for employees whose employers held onto their portion too long, and brought 159 indictments, Rosen said.

More often than not, the source of the problem is a misunderstanding of the rules defining "reasonably segregable," rather than malfeasance, said Bob Regan, vice president of defined contribution services at Boston Financial Data Services. The rule states that the remittance must be made no later than 15 days after paychecks are issued. "That is not a safe harbor," Regan said. If payment can be made earlier, it must be. Otherwise, employers and their service providers could face penalties.

Sponsors and their service providers must also be mindful that all vesting calculations are accurate, and any "break-in-service" rules are accurately reflected.

Other frequent foibles involve plan loans. For example, securing spousal consent, preparing proper documentation and suspending employees' deferrals during the loan period are the types of details that too often slip through the cracks. Often, loan recipients' distributions are not properly reported on tax form 1099, and therefore are not subjected to the excise taxes required by law.

Plans also face problems because their assets are not well enough diversified, they bear unduly large administrative costs, or their assets are lumped together as "other assets" on the balance sheet.