Retirement plans are funded by contributions from employers and/or employees, depending upon the type of plan and the provisions established under the plan document. These contributions must be deposited to the trust established under the plan by certain dates.
Prior to the last decade, contribution timing issues centered around the minimum funding rules (which only apply to pension plans) and tax deduction rules. However, in recent years the 401(k) plan has become the most popular retirement vehicle in existence. With it has come a greater emphasis on the timing of a variety of contribution options that are available under such plans. Unfortunately, not all of the deposit deadlines for these plans are as clear-cut as one might expect.
The key component of a 401(k) plan is that it allows employees to defer a portion of their compensation into the plan, up to certain allowable limits. An individual account is typically established for each participant, who is often permitted to direct the investment of his or her account.
Other contributions may be made by the employer, such as matching contributions, safe harbor contributions and qualified non-elective contributions, some of which are based on employees’ deferrals.
Since deferrals are deducted from employees’ wages on a regular basis (usually each paycheck), the issue has always been how quickly the deferrals must be transmitted to the plan. It is an issue which has generated much debate.
The Department of Labor (DOL) issued final regulation sec. 2510.3-102 years ago to address this subject, but it may have resulted in more confusion than clarification. Under the regulation, amounts that are paid by a participant or withheld from wages by an employer become plan assets as of the earliest date on which such contributions can reasonably be segregated from the employer’s general assets. The regulation does not, however, specify what a reasonable time period might be in which to implement this segregation. In an electronic society where most financial transactions are done by computer, this “segregation” concept seems antiquated. Nevertheless, since many employers remit taxes within days of withholding, it’s hard to argue against that same capability for withheld deferrals.
The regulation also states that in no event shall the segregation date be later than the 15th business day of the month following the month the contribution was received or withheld. Some employers who apparently relied upon this date as a safe harbor deadline eventually paid the price. The Internet is abuzz with tales of DOL audits in which employers, who believed they were acting within the regulation, were penalized for failure to remit salary deferrals on a timely basis. As a result, employers should consider remitting participant contributions as soon as possible and, in no event, less frequently than they make their tax deposits.
If participant contributions are not immediately deposited into the plan once they are considered to be plan assets, then the employer is engaging in a prohibited transaction. That’s because the employer has use of the money that belongs to the plan, which is a violation of ERISA. Prohibited transaction penalties could apply, as well as possible replacement of lost earnings and other penalties for breach of fiduciary duties.
This issue was litigated in federal court for the first time earlier this year. To the surprise of many, the judge sided with a failing “dot com” company in refusing to find that deferrals deposited as late as the 15th day of the following month were beyond DOL requirements. The DOL would likely disagree with the outcome of this case, and employers who rely on it do so at their own peril.
Loans to plan participants, secured by their vested benefits, are more common in 401(k) plans than any other plan. Repayments are often deducted from the employee’s wages, similar to salary deferrals. In a recent advisory opinion (2002-01A, May 17, 2002), the DOL compared loan repayments to participant contributions and stated that they too become plan assets as of the earliest date they can reasonably be segregated from the employer’s general assets. Although the DOL had previously said that loan repayments were not within the scope of the final regulations, this advisory opinion makes it clear they will receive similar treatment.
To entice employees to participate in their 401(k) plans, employers will often make a contribution to participants who defer a portion of their compensation into the plan. Such contributions are called matching contributions and are usually based on the amount of each participant’s deferrals. Some employers deposit these contributions on a regular basis throughout the year, while others deposit the entire amount after the plan year-end.
In order to be allocated in the current year and included in the non-discrimination test (see next section), matching contributions must be deposited by the last day of the following plan year. But in order to be deducted on the employer’s tax return for the year for which they are allocated, the matching contributions must be contributed by the due date of the employer’s tax return, including extensions. (This assumes the employer’s fiscal year is the same as the plan year. Where it is not, other rules apply.)
Example: ABC Company’s fiscal and 401(k) plan year are both the calendar year. The company always deposits the entire matching contribution after the plan year-end. For 2001, ABC has filed for an extension (to September 16, 2002) to file its federal tax return. The matching contribution is made September 4, 2002. Since it was contributed before the federal tax return due date (including the extension) it is deductible on the 2001 return. (This example assumes that the contributions are within the 2001 15% deduction limit.)
Each year a separate non-discrimination test must be performed for salary deferrals (ADP test) and matching and/or voluntary contributions (ACP test) under a 401(k) plan. One method of passing an otherwise failed test is for the employer to make a qualified non-elective contribution (QNEC) or a qualified matching contribution (QMAC) to some or all of the non-highly compensated employees. In order to be utilized in the test for a particular plan year, these contributions must be made by the last day of the following plan year. The timing issues that apply to the deduction of matching contributions also apply to QNEC and QMAC contributions.
A 401(k) plan will be treated as automatically passing the ADP test for any year that it satisfies the safe harbor contribution requirement and the notice requirement. The contribution requirement can be met by either a specified matching contribution rate or an employer non-elective contribution of 3% of eligible employees’ compensation.
Generally, the safe harbor contribution must be made by the last day of the following plan year. The timing issues that apply to the deduction of matching contributions also apply to safe harbor contributions.
Where the safe harbor matching contribution is being made on a per payroll basis instead of an annual compensation basis, the match must be deposited by the last day of the following plan year quarter.
Employer non-elective contributions to a profit sharing plan are generally credited in the year they are deposited. However, contributions made after the end of the employer’s fiscal year but before the due date for filing its federal tax return (including extensions) may be considered to have been paid as of the last day of the fiscal year. If the employer’s fiscal year is different than the plan year, other factors may have to be considered.
Example: The XYZ Corporation’s fiscal year is the calendar year. XYZ’s profit sharing plan also has a calendar plan year. For 2001, the due date of XYZ’s federal tax return was extended to September 16, 2002. Any employer contributions deposited by that date can be considered deposited on December 31, 2001 and allocated under the plan as of that date. They would be deductible to the corporation for 2001.
Unlike profit sharing plans, in which employer contributions are often discretionary, money purchase pension plans require a specific contribution formula. Failure to deposit the required contribution is a violation of the minimum funding standards. The contribution deadline for minimum funding purposes is 8½ months after the end of the plan year. If the deadline is not met the employer is subject to a late funding penalty.
Where the employer’s fiscal year is the same as the plan year, this date matches the day a corporation could extend the due date of its tax return. This allows the employer to deduct the payments necessary to fully fund the plan within the allowable funding period. However, the 8½ month funding period exists regardless of whether or not the corporation files for an extension.
Non-corporate entities such as partnerships and sole proprietors have different tax filing due dates which must be taken into consideration for deduction purposes.
If a plan is considered to be top heavy (i.e., at least 60% of the benefits belong to key employees), it must provide minimum contributions, usually 3% of compensation, to non-key employees. Such top heavy contributions must be paid by the last day of the following plan year. The timing issues that apply to the deduction of matching contributions also apply to top heavy contributions.
The funding requirements for defined benefit pension plans are based on actuarial calculations which spread out payments over the years to provide for specific benefits as they become due. As with money purchase plans, defined benefit plans are also subject to the minimum funding rules, which allow required contributions to be made up to 8½ months after the end of the plan year.
Plans that do not contribute enough money to fully fund the current benefit liabilities must make deposits on a quarterly basis or else notify employees that quarterly deposits will not be made. The timing issues that apply to the deduction of money purchase plan contributions also apply to defined benefit plan contributions.
It is important for plan sponsors to know the required due dates for contributions to their qualified retirement plans. This will enable them to take full advantage of contribution opportunities and prevent late penalties for failure to timely contribute. With the increased popularity of the 401(k) plan, the timing of salary deferral contributions has become an important issue.
While DOL regulations are not crystal clear as to the deadline for the transmittal of these contributions, it is clear that the 15th business day of the following month rule is not a safe harbor deadline upon which employers can rely. Prudence dictates the deposit of these funds as soon as practical, to avoid any possible prohibited transaction penalties or other adverse ramifications.
With so many different types of contributions available in retirement plans today, it is important to double-check the due dates to avoid confusion.
This newsletter is intended to provide general information on matters of interest in the area of qualified retirement plans and is distributed with the understanding that the publisher and distributor are not rendering legal, tax or other professional advice. Readers should not act or rely on any information in this newsletter without first seeking the advice of an independent tax advisor such as an attorney or CPA.