Your clients who sponsor retirement plans put in a lot of time and effort to keep their plans in compliance. Many dollars and hours go into making sure that they are following the tax laws for their qualified retirement plans. But, why? What happens if they don’t follow the laws?
If your clients fail to comply with the tax laws governing retirement plans, the IRS can disqualify their retirement plan.
What is Plan Disqualification?
When the IRS disqualifies a retirement plan, they essentially take away the tax-exempt status of the trust. The retirement plan trust becomes taxable. The consequences of this affect everyone involved, from the plan participants to the sponsoring company.
Consequences of Plan Disqualification
For the years that a plan is disqualified, participants have to count any employer contributions toward their gross income, as long as they are fully vested. They have to pay federal income taxes on everything the employer contributes for them, which they wouldn’t otherwise have to do.
The consequences can be even more dire for highly compensated employees. When the plan is disqualified for certain reasons, they have to count their entire vested pre-tax account balance as income and pay taxes on the whole amount.
Under a qualified plan, plan sponsors are able to immediately deduct the contributions they make. When a plan is disqualified, those deductions may be restricted and delayed. Also, there are different rules regarding the amount of deductible contributions and the timing of them when a plan is disqualified.
Plan sponsors cannot deduct their contributions until they have been included in the participant’s gross income. If your client sponsors a defined benefit plan or any other plan that doesn’t maintain separate accounts for each employee, they cannot take any deduction at all for their contributions.
Earnings & Distributions
Disqualification makes the plan’s trust taxable, which means the trust has to pay income tax on all of its earnings. Qualified plans are tax-exempt and don’t pay taxes on earnings. Rather, the earnings are taxed when distributed to the plan participants.
Distributions from a plan that has lost its qualified status are not considered eligible rollovers. This means that participants cannot roll their funds over to an IRA or another employer’s qualified retirement plan. Instead, all distributions are taxable to the participant in the year that they are received.
How to Regain Qualified Status
If your client wants their plan requalified by the IRS, they have to first fix the error that led to the loss of their tax-exempt status in the first place. They can make corrections through the IRS Voluntary Correction Program. However, they will have to make use of the Audit Closing Agreement Plan if their plan is already being examined by the IRS.
How to Prevent Plan Disqualification
As you can see, the last thing your clients want is for their retirement plan to lose its qualified status with the IRS. To prevent disqualification, they need to be proactive. They need to do their own audit, detect any errors, and fix them before the IRS forces them to. According to the IRS, these are the top ten plan errors that lead to disqualification:
- Failure to amend the plan for tax law changes by the required date
- Failure to follow the plan’s definition of compensation for purposes of determining contributions
- Failure to include eligible employees in the plan or to exclude ineligible employees from the plan
- Failure to satisfy plan loan provisions
- Impermissible in-service withdrawals
- Failure to satisfy required minimum distribution rules
- Employer eligibility failure
- Failure to pass annual nondiscrimination testing
- Failure to properly provide the minimum top-heavy benefit or contribution to non-key employees
- Failure to observe the limits on maximum annual contributions a participant can receive (in a defined contribution plan) or the amount of benefits a participant can accrue (in a defined benefit plan)
Going back and looking for errors such as these and then fixing them can be a long and tedious process. Many plan sponsors choose to work with a specialized retirement plan consultant for things like this because it can save both time and money.
If you have clients who need help cleaning up their plans to avoid disqualification or who have been disqualified and need help regaining their qualified status, I can help. Email me today at firstname.lastname@example.org and we can set up a time to discuss how I can help your clients maintain or regain their qualified status with the IRS.
About Kenny Phan
Kenny Phan is a Managing Partner at FinancialFocus Retirement Plan Services, a 3(16) fiduciary. He works as a pension specialist who partners with financial professionals to design and implement pension plans. His area of expertise is customized defined benefit, defined contribution, and 401(k) plans. Serving financial advisors and businesses in the greater Phoenix area, he is supported by FinancialFocus Retirement Plan Services. Together, they provide comprehensive plan design consultation, administration, document installation, compliance testing, as well as IRS and DOL reporting for qualified retirement plans.