Most employers and a fair number of individuals worry only about an IRS audit of their income tax returns. Unfortunately, the agency can perform another kind of audit that not only may take you by surprise, but also can leave you with a rather shocking result: a disqualified 401(k) plan — and a bevy of potentially nasty tax consequences for you and your employees.

Typical triggers

What could cause such a sorry state of affairs? Plan disqualification can be triggered by:

• Failing to identify all employees eligible for your 401(k),
• Neglecting to give participants the opportunity to make deferral elections, and
• Not limiting employee contributions to the amounts allowed under tax law for the calendar year.

In addition, traditional 401(k) plans must be regularly tested to ensure that the contributions don’t discriminate in favor of highly compensated employees. So, your 401(k) must pass all applicable nondiscrimination tests.

Loss of status

Tax law and administrative details that may seem trivial or irrelevant may actually be critical to maintaining a plan’s qualified status. If a plan loses its qualified status, each participant is taxed on the value of his or her vested benefits as of the disqualification date. That can result in large (and completely unexpected) tax liabilities for participants.

In addition, contributions and earnings that occur after the disqualification date must be included in participants’ taxable incomes. The employer’s tax deductions for plan contributions are also at risk. And there are penalties and fees that can be devastating to a business. Finally, withdrawals made after the disqualification date cannot be rolled over into other tax-favored retirement plans or accounts (such as IRAs).

A preventable problem

Naturally, an employer isn’t without recourse if its 401(k) plan is in danger of disqualification because of an IRS audit. You may be able to follow a voluntary correction process to rectify the problem. And, of course, you can prevent the situation by keeping careful track of plan compliance. Questions? Give us a call.