David J. Kupstas, FSA, EA, MSEA Chief Actuary
Did your parents or a teacher ever threaten you with dire consequences in order to correct an undesirable behavior? “If you cross your eyes, they’ll get stuck that way.” “Young man, this will go on your permanent record!”
We in the pension business have our own threat we can give clients. “If you don’t follow the rules, the IRS will disqualify your plan!” Even if you don’t know what that means, it sounds pretty scary and is probably enough to set most people on the right path. But what does it mean? In short, it means bad news for everyone involved: the employees, the sponsoring employer, and the plan itself.
- For the employees: Part of the draw of a qualified retirement plan is that an employee doesn’t have to pay taxes on the contributions until the money is withdrawn. When a plan is disqualified, the employee has to pay taxes immediately on the contributions to the extent those contributions are vested. A distribution from a plan that has been disqualified cannot be rolled over tax-deferred to another workplace plan or an IRA. When a disqualified plan distributes benefits, they are subject to taxation.
- For the employer: The timing of the tax deductions may change, or the deductions may be limited. Whereas contributions to a qualified trust are generally deductible when made, the contributions to a nonexempt employees’ trust cannot be deducted until the contribution is includible in the employee’s gross income. Also, FICA and FUTA taxes would be owed for contributions as soon as they are vested.
- For the plan: When a retirement plan is disqualified, the plan’s trust loses its tax-exempt status and must file Form 1041, U.S. Income Tax Return for Estates and Trusts, and pay income tax on trust earnings.
The good news is that it is very rare for a plan to be disqualified. The IRS is reluctant to disqualify plans because it is poor policy to tax retirement savings. The IRS would rather use lesser sanctions to encourage future compliance.
If your plan fails to satisfy the rules for some reason, there are steps you can take before the plan is disqualified. Very minor infractions may be corrected with no sanctions using the Self-Correction program. Other errors may be corrected with just a minor sanction through the Voluntary Compliance Program (VCP). Both Self-Correction and VCP rely on plan sponsors to ‘fess up to their sins voluntarily. If a defect is uncovered on audit, the Audit Closing Agreement Program (Audit CAP) is available. Penalties are stiffer under Audit CAP as compared to Self-Correction and VCP, but still not nearly as bad as having the plan disqualified.
While it looks like we didn’t have to worry about our eyes staying crossed, the threat of plan disqualification is something to take seriously. Fortunately, it is a punishment given only to the most egregious violators. If you try to operate your plan according to the rules and fix problems quickly if you are outside the rules, you should generally stay out of trouble — and keep bad marks off your permanent record.