When a business reaches a certain number of eligible participants for their 401(k) plan, federal law requires an independent audit of that retirement plan. Larger companies are more accustomed to this annual requirement. However, owners and managers of growing businesses may never have experienced a 401(k) audit or don't know enough about it.
You probably have a lot of questions if you’re about to undergo an audit for the first time. At what point is an employer required to complete a 401(k) audit? What is an "eligible participant," and why is this important? Who performs the audit, and what documents do they need?
A little homework will help you determine whether or not a 401(k) audit is required. Plus, it’ll help you better prepare for one.
What is a 401(k) Audit?
A 401(k) audit is an annual analysis of your company’s 401(k) plan performed by an external entity. These audits are mandated under the Employee Retirement Income Security Act of 1974 (ERISA) — a federal law detailing the minimum standards for businesses’ voluntary retirement and health plans. The primary objective of an audit is to ensure the retirement plan you offer meets ERISA standards and the specific requirements of your company's 401(k) plan.
The audit will uncover any parts of the plan that are not in compliance and allow you to take corrective action, thereby minimizing risk to your employees and your company. Independent certified public accountants or third-party auditors conduct 401(k) audits to ensure unbiased results.
401(k) audits are a way to ensure that the rights of your employees are protected. They were first mandated after carmaker Studebaker terminated their pension plan in 1963, leaving workers without retirement funds.
What Companies are Required to Conduct a 401(k) Audit?
A company is required to conduct a 401(k) audit if its plan has a certain number of eligible participants at the beginning of the plan year. Generally speaking, a company only needs to conduct an audit if they have 100 or more eligible participants in the plan (considered a “large plan”).
However, there is an exception that helps growing businesses. If your total number of participants fluctuates between 80 and 120, you can hold off on an audit until you begin a plan year with 121 or more participants. This is known as the “80-120 participants rule.” While your plan will be considered a large plan at the 100-participant threshold, you could have one or more years to go before you’re required to complete an audit under this rule.
Once your plan is considered a large plan and you've crossed the 120 eligible participants threshold, you'll need to conduct audits in the future. You'll continue to file your Form 5500 as a “large plan” unless the eligible participant level dips below 100, in which case it’ll be considered a “small plan.”
Who is an Eligible Participant?
In a qualified plan, employees are considered eligible participants if they meet these requirements:
- They are a current employee eligible to contribute to the company's 401(k) plan, whether they're participating in the plan or not. The point at which an employee becomes eligible will be outlined in your plan document and may be defined by how long they've worked at your company.
- They are a former employee with funds in the company's 401(k) plan.
Add those two groups together, and if you come up with 121 or more on the first day of the plan year, then you will be required to complete a plan audit.
What Does the Audit Cover?
While a service provider and an accountant may perform audits differently, they all focus on several general points.
- Reviewing 401(k) plan documents you provided to verify your plan is compliant with IRS and Department of Labor rules
- Looking for any amendments made to the plan during the year
- Determining the accuracy of the information reported on Form 5500 Annual Return/Report of Employee Benefit Plan and the 401(k) financial statements
- Assessing how your company maintains electronic 401(k) records
- Comparing employee contributions with remittance dates to ensure the funds were remitted in a timely manner
- Confirming distributions and rollovers were paid out properly
- Sampling specific participant’s transactions to further ensure compliance
- Interviewing upper management to vet any concerns
This extensive process can last anywhere from three to four months, depending on the quality of and access to your data. Average-sized businesses can see audit costs of $10,000 to $12,000, with Fortune 500 companies seeing higher bills.
How Do You Prepare for an Audit?
The simplest way to prepare for an audit is to keep track of plan-related documents throughout the year. In addition, audit document requirements include the most recent Form 5500 as well as W-2s, loan requests, loan repayments, distributions, and other information related to your employees and their 401(k) activity.
For smaller companies experiencing steady growth, it’s important to monitor the number of eligible participants you have in your plan. Planning will prevent any surprises and give you a head start in tracking the necessary documents leading up to your first audit.
Regardless of the size of your plan, be sure to consult your 401(k) provider for assistance in gathering the necessary information for your plan auditor. They can also work directly with your auditor to reduce the amount of time you’re involved in the project. According to the Chief Executive Officer of ERISA Consultants, Richard Phillips, it’s important to thoroughly research your service provider beforehand to ensure a seamless audit.
“Vet your service provider. Make sure you’ve done your due diligence so that you know you have good support from them and know they can provide the documents and records that are needed to make it a smooth audit process,” Phillips states.
What Common Errors Should I Keep an Eye Out For?
The auditor may discover some administrative errors in your 401(k) plan as they evaluate it. If so, work with your plan provider to rectify them as soon as possible to avoid getting into any noncompliance issues. Here are the most common ones that you should expect:
Using the Wrong Definition of Eligible Compensation
Your 401(k) plan document must correctly define the type of compensation you use for determining employee deferrals and matching contributions. This is known as “eligible compensation.” Your definition should include or exclude certain types of compensation, such as bonuses, overtime pay, and commissions.
Not using the plan definition will lead to incorrect deferrals and matching contributions. This usually happens when a company changes its third-party administrator (TPA), and creates a new document that doesn’t include previous definitions.
Fixing this mistake depends on whether your eligible employees have deferred more or less than what was required. For instance, excess deferrals (and earnings) can't stay in the employee account and are to be reallocated per IRS guidelines. The IRS has a detailed, step-by-step guide on how to fix this mistake.
Hardship Distribution Eligibility Errors
Employees who need financial help due to an immediate (usually unforeseen) need can apply for a “hardship distribution.” This option grants them access to a limited amount of funds in their retirement plan. A hardship distribution should only be enough to cover the financial need, and the employee has to show that they weren’t able to obtain funds elsewhere. Plan sponsors often make the mistake of approving hardship distributions for employees who don’t qualify for one.
What’s more, some plans state that participants cannot contribute to the plan for a certain number of months after receiving a hardship distribution. The participants and the administrators may not be aware of or forget about this rule.
The only way to rectify this mistake is to speak to the participant who didn’t qualify for the hardship distribution and have them return the amount along with earnings when possible. If the participant continued to make payments immediately after receiving the funds, use the contributed amount to account for all or a portion of the invalid distribution.
Employers are required to deposit participant contributions to a retirement plan in a timely manner. Failure to do so may lead to fines or even the disqualification of your plan. A rule of thumb is to remit the contributions before the 15th of the following month after they’re withheld.
You may choose a different timeframe based on your specific processes and requirements. Whatever the case, define that timeframe in your plan document. Depositing late contributions is the only remedy. Make sure to also report them on your Form 5500 if that happens.
What Comes After the 401(k) Audit?
Once your independent 401(k) audit is completed, you'll attach the report to Form 5500. All businesses with 401(k) plans must file Form 5500 Annual Return/Report of Employee Benefit Plan. This annual report, registered with the Department of Labor (DOL) and the Internal Revenue Service (IRS), provides information on your 401(k) or other benefit plans.
Information collected includes the type of plan, the plan sponsor's information, the plan administrator's information if it's different, and the number of participants. It's the source for determining whether your plan is considered small or large and whether you've crossed the eligible participant threshold and will be required to complete an annual audit going forward.
Form 5500 comes with a dizzying 28 pages of instructions. Luckily, your 401(k) provider, along with your independent auditor, will take care of the tricky work to fulfill this annual requirement.