The Internal Revenue Service has issued new guidelines that should be advantageous for employers that sponsor 401(k) and 403(b) plans. The new rules reduce and, in some cases, completely eliminate the windfall in favor of employees who are affected by a mistake involving missed employee elective deferrals.

This mistake may involve either the improper exclusion of an eligible employee from a 401(k) or 403(b) plan or the failure to implement an employee's deferral election, including the use of the wrong definition of compensation in calculating deferrals.

Missed deferral errors are one of the most common operational errors in 401(k) and 403(b) plans and typically have been one of the most expensive kinds of errors to correct. Existing correction guidelines in the IRS' Employee Plans Compliance Resolution System provide a windfall to affected employees. Affected employees are allowed to keep the overpayment of their compensation that results from a missed elective deferral and also receive an additional "free" contribution in the 401(k) or 403(b) plan equal to 50 percent of the employee's missed elective deferral.

The new rules are effective now and should be useful in situations in which a missed deferral error is discovered during the plan's annual financial statement audit or while preparing the plan's Form 5500. The new rules will be especially useful to plans that have either automatic enrollment or automatic escalation of elective deferrals. Additional relief is available for plans that have missed deferrals errors over a short period of time—up to two years.

Employee Elective Deferral Failure Defined. The new correction rules apply to "Employee Elective Deferral Failures" ("EEDF" in this E-Alert), which is a new term that the IRS has defined as:

a failure to correctly implement elective deferrals in a § 401(k) plan or § 403(b) Plan including elective deferrals pursuant to an affirmative election or pursuant to an automatic contribution feature (including an automatic escalation feature) and a failure to afford an employee the opportunity to make an affirmative election because the employee was improperly excluded from the plan.

Automatic Enrollment or Automatic Escalation Errors. The most generous relief—complete elimination of all windfall contributions—is provided for missed deferral errors that involve a plan's automatic enrollment or automatic escalation provisions. These provisions are referred to by the IRS as automatic contribution features.

Employers are no longer required to contribute 50 percent of the employee's missed elective deferral if the EEDF involves the failure to implement an automatic contribution feature and if the following requirements are satisfied:

• the failure must not last longer than 9-1/2 months on or after the end of the plan year of the failure. This coincides with the extended filing deadline for Form 5500.
• correct deferrals must begin with the first payment of compensation after the 9-1/2 month period, or if earlier, the last day of the month following the month in which the employee notifies the employer.
• notice is given to the affected employee within 45 days after correct deferrals begin containing the information specified in Revenue Procedure 2015-28.
• missed matching contributions (adjusted for earnings) are credited to the affected employee's plan account.

This relief is also available for errors involving the failure to implement an affirmative election of an employee who is otherwise subject to an automatic contribution feature.

Unless extended by the IRS, the relief for errors involving automatic contribution features will not apply to errors that begin after December 31, 2020.

EEDFs That Do Not Exceed Three Months. The same relief as described above is available for any missed deferral error that does not exceed three months. This rule creates a rolling three-month correction period in which employers will not be required to contribute 50 percent of the employee's missed elective deferral if requirements similar to those that are described above are satisfied. This relief is available even if the plan does not have an automatic contribution feature.

EEDFs That Exceed Three Months But Do Not Exceed Two Years. Limited, but not complete, relief, is also provided if the missed deferral error exceeds three months or if the conditions for any of the other relief in Revenue Procedure 2015-28 are not met. Under this rule, an employer is required to contribution 25 percent (but not 50 percent) of the employee's missed elective deferral. This rule is subject to requirements similar to those that are described above. This relief is only available if correct deferrals begin with the first payment of compensation on or after the last day of the second plan year following the plan year in which the failure occurred, or if earlier, the last day of the month following the month in which the employee notifies the employer.