Consequences of Plan Disqualification
A tax-qualified retirement plan, such as a 401(k) plan, provides you, as the employer, and the employees who participate in your plan with numerous advantages. These advantages are lost if you fail to follow tax law requirements and your retirement plan loses its qualified status.
Essentially, when the IRS disqualifies a plan, the plan’s trust ceases to be tax exempt. Instead, it becomes a nonexempt (or taxable) trust. This status change affects plan participants, the employer, and the trust.
For Plan Participants
Generally, participants must include in gross income any amounts the employer contributed to the plan for their benefit in the years the plan is disqualified (to the extent the participant is vested in those contributions). As a result, participants are subject to current federal income tax on those contributions. Highly compensated employees may have to include their entire vested plan balance in income (any amount not previously taxed) if the plan is disqualified for certain reasons.
In addition, distributions from a plan that has been disqualified are not considered eligible rollover distributions. Consequently, employees receiving distributions cannot roll them over to an individual retirement account or another employer’s retirement plan. Distributions generally are taxable to the recipients in the year they are received.
For Employers
If your retirement plan is disqualified, your deductions for contributions to the plan could be restricted and delayed. Once a plan is disqualified, different rules apply to the amount an employer can deduct for plan contributions and when deductions are allowed. Unlike contributions to a qualified plan, contributions to a nonexempt employees’ trust cannot be deducted until the contributions are includable in employees’ gross income. Employers that sponsor a defined benefit plan (or other plan that does not maintain separate accounts for each employee) cannot deduct any contributions.
For the Plan Trust
When a plan is disqualified, the plan trust must pay income tax on the trust earnings. Qualified plan earnings are not taxed to the plan trust but, rather, generally, to plan participants in the year those earnings are distributed to them from the plan.
Regaining Tax-exempt Status
Before the IRS will reinstate a plan’s qualified status, generally, the error that caused the disqualification has to be corrected. Corrections can be made through the IRS Voluntary Correction Program or, if the plan is under examination by the IRS, through the Audit Closing Agreement Program.
Top Ten Plan Errors
- 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 nonkey 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)
Source: IRS, 2011
“If your retirement plan is disqualified, your deductions for contributions to the plan could be restricted and delayed.”
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