Tax Consequences of 401(k) Plan Disqualification

I had a great question today – what happens when the IRS disqualifies a 401(k) plan?

What they really wanted to know is what happens to the non-elective contributions made by the employer into the plan, and how would a plan disqualification affect them (the person asking the question wears 2 hats when it comes to his 401(k) plan – he is both the plan sponsor and one of the participants in the plan.)

While most answers can be found by reading the plan document, this is not true when is comes to the tax consequences of plan disqualification. Most plan documents will say something about how the contributions made by the employer can be returned to the employer if the plan fails to initially qualify, but most plan documents do not address the specifics of the tax consequences of plan disqualification.

One of the reasons why this is true is that the tax consequences of plan disqualification can vary depending on who is asking the question, because the tax consequences of plan disqualification affect employees, employers, and the plan’s trust differently.

The IRS has put together a great website discussing this issue. It includes examples, such as this example about the tax consequences of plan disqualification on an employee:

Example: Pat is a participant in the XYZ Profit-Sharing Plan. The plan has immediate vesting of all employer contributions. In calendar year 1, the employer makes a $3,000 contribution to the trust under the plan for Pat’s benefit. In calendar year 2, the employer contributes $4,000 to the trust for Pat’s benefit. In calendar year 2, the IRS disqualifies the plan retroactively to the beginning of calendar year 1.

Consequence 1: General Rule – Employees Include Contributions in Gross Income
Generally, an employee would include in income any employer contributions made to the trust for his or her benefit in the calendar years the plan is disqualified to the extent the employee is vested in those contributions.

In our example, Pat would have to include $3,000 in her income in calendar year 1 and $4,000 in her income in calendar year 2 to reflect the employer contributions paid to the trust for her benefit in each of those calendar years. If Pat was only 20% vested in her employer contributions in calendar year 1, then she would only include $600 in her calendar year 1 income.

Exceptions: There are exceptions to the general rule (see IRC section 402(b)(4)):

  • If one of the reasons the plan is disqualified is for failure to meet either the additional participation or minimum coverage requirements (see IRC sections 401(a)(26) and 410(b)) and Pat is a highly compensated employee (see IRC section 414(q)), then Pat would include all of her vested account balance (any amount that wasn’t already taxed) in her income. A non-highly compensated employee would only include employer contributions made to his or her account in the years that the plan is not qualified to the extent the employee is vested in those contributions.
  • If the sole reason the plan is disqualified is that it fails either the additional participation or minimum coverage requirements, and Pat is a highly compensated employee, then Pat still would include any previously untaxed amount of her entire vested account balance in her income. Non-highly compensated employees, however, don’t include in income any employer contributions made to their accounts in the disqualified years in that case until the amounts are paid to them.
    Note: Any failure to satisfy the nondiscrimination requirements (see IRC section 401(a)(4)) is considered a failure to meet the minimum coverage requirements.”

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