What Happens if My 401(k) Plan is Out of Compliance with an IRS or DOL Rule?

Paul McEwan | May 22nd, 2013

With all of the rules in the business world, it sometimes can be difficult to know and understand all of the rules we need to follow – there are a lot of them. So what happens if you find yourself in an unintended situation where your business’s 401(k) plan is out of compliance? Simply put, a plan out of compliance with Internal Revenue Service (IRS) or Department of Labor (DOL) rules is subject to disqualification. But what does that mean? It is very important that you fix any compliance issues when they are identified – whether they are document-related issues, government reporting issues (5500) or plan operational issues.

Plan Disqualification 101 – The Basics

Congress has extended to retirement plans three valuable tax benefits:

  1. Immediate deduction for employer contributions
  2. No tax on retirement plan trust earnings
  3. Deferral of participant taxation on contributions until distribution.

You will only receive tax benefits if your plan meets the qualification requirements in both form (document) and in operation. The disqualification of the plan by the IRS can result in serious tax consequences for both you – as the employer – and your employees. Many plan errors often are discovered by the IRS and practitioners years after they occur.

Principal tax consequences if a retirement plan is disqualified

When a plan is disqualified by the IRS, the plan loses its three tax benefits which are:

  1. The trust income is taxable.
  2. The employer only may deduct vested contributions (i.e., loses the deduction for non-vested contributions).
  3. The employee takes into gross income contributions to the extent they are vested. With respect to non-vested contributions, the employer can deduct such contributions in later years as they become vested. When the non-vested contributions become vested in later years, the employee would include such contributions in his/her gross income.

Additional Consequences

Losing your plan’s tax benefits are not the only consequences you might face if your plan is disqualified. You may face three other major consequences:

  1. Amounts from the plan cannot be rolled over.
  2. Employer contributions are subject to payroll taxes when vested.
  3. The participant is taxed on remaining amounts when they are made available, rather than deferring income until receipt of the distribution.

Ohio 401(k) Help

If you sense something is not right with your 401(k) offering or become aware of a problem with your plan, contact Rea & Associates. Our Ohio Retirement Plan Services team can help you correct any problems and minimize potential penalties and taxes.


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