ERISA 401(k) employee contribution rules

HR and benefits professionals talk a lot about the importance of employees contributing to their 401(k) plan. But the employer plays a significant role in the process by depositing those contributions into the 401(k) plan in a timely manner. 

When an employer acts as a plan sponsor for a 401(k) plan, it’s acting in a fiduciary capacity under the Employee Retirement Income Security Act of 1974 (ERISA). There are two key ERISA fiduciary duties relevant to collecting employee contributions and loan payments (collectively “contributions”) from payroll:

1. The employer must have the knowledge required to act or make decisions for the plan (often called the “duty of prudence”).This means that the employer must understand the laws related to employee contributions taken from payroll or seek the advice of an expert when designing its contribution process.

2. The employer must always put the best interest of the plan participants and beneficiaries above its own. This means that the employer must move employee contributions from its bank account to the plan’s trust in the required timeframe. Holding onto employee contributions so the employer has use of the funds a bit longer is a violation of this duty. 

Missed contributions from payroll

The responsibility of plan sponsors to deposit employee contributions may seem obvious. However, not all plan sponsors make deposits as required, often due to a lack of prioritization or understanding. It’s important for employers to ensure employee contributions are timely deposited, as the DOL may audit a plan that reports late contributions on the Form 5500 (as required). 

Determining when employee contributions must be deposited

Under ERISA, all employers must deposit employee contributions to the trust on the earliest date that it can segregate the contributions from its general account, but in no event later than the fifteenth business day of the following month. Failure to make contributions in the required timeframe results in a prohibited transaction caused by the employer. 

Small plans, defined as those with less than 100 participants on the first day of the plan year, can take advantage of a seven-business-day “safe harbor” when depositing employee contributions to the plan. Under that rule, employee contributions are deemed to have been timely made if they’re deposited into the plan’s trust within seven business days after the applicable payroll date. 

Large plans, defined as those with 100 or more participants on the first day of the plan year, do not qualify for the safe harbor. Instead, they’re subject to scrutiny by the DOL and if applicable, their plan auditor, to determine how quickly payroll deposits can be made. Large plans typically deposit employee contributions within five business days, but each employer must analyze its own payroll process to determine the correct number of days for its plan.

Correcting late contributions

Mistakes happen, and a late deposit isn’t the end of the world. However, when the employer realizes that a contribution deposit is late, it must immediately take action to resolve the problem. The employer has two options for correction. 

1. Self-correction: Plan sponsors may take a self-correction approach following the steps outlined below:

1. Deposit the contributions to the plan, if not already done;

2. Calculate lost earnings owed to the participants for the period of time that the contributions should have been in the plan and were not;

3. Fund and allocate lost earnings to affected participants 

4. File Form 5330 and pay a 15% excise tax penalty on the prohibited transaction.

Self-correction is not an official correction method that is approved by the Department of Labor (DOL) but is commonly used. Some plan sponsors who use self-correction will receive a letter from the DOL suggesting that VFCP (discussed below) be used.  

2. Correction with DOL approval: A plan sponsor may also use the DOL’s Voluntary Fiduciary Correction Program (VFCP)  to correct late contributions. To use VFCP, the plan sponsor files an application with the DOL. At this time, there is no cost for filing a VFCP application. A plan sponsor may complete the application themselves or hire an attorney to assist. The Form 5330 and excise tax penalty may be waived in certain circumstances when using VFCP.

Once the VFCP is approved, the DOL will issue a no-action letter. This provides the plan sponsor with the assurance that the DOL will not recommend the plan for an audit based on late contributions and may waive any civil penalties associated with the filing. 

Ignoring late deposits is never recommended. The cost of correction will continue to increase until corrected. In addition, the IRS and DOL may audit the plan and impose fines and penalties on the employer for failure to correct. In some cases, the plan may even be disqualified. If an employer discovers it has an issue with late deposit of employee contributions, the best course of action is to make corrections as soon as possible.

Note: More information on correction options for late deferrals can be found in the IRS 401(k) Plan Fix-It Guide.