Testing Treatment of Terminees for Compensation Paid in the Following Year (Posted June 8, 2004) Technical Tip 122: The following question and answer were from the IRS Q&A Session at the 2002 ASPPA Annual Conference: A 401(k) plan participant terminates 12/30/01.The plan is a calendar year plan. The participant receives pay through 1/15/02. 401(k) deferrals are withheld from 2002 compensation. How is this person treated in the 401(k) testing? In a safe harbor plan, does this participant receive a contribution in 2002? Response: The person is not a participant in 2002 and should not have deferrals in 2002. Comment by the RLR&C ERISA attorneys: The IRS' answer reflects the rule that only current employees are eligible to have a portion of their compensation deferred under a 401(k) plan. (See Treas. Regs. section 1.401(k)-1(a)(3)). (The IRS' answer would be more accurate if it highlighted the fact that the individual is not an employee for 2002, rather than not being a participant for the year.) In the Q&A, amounts were deferred from and individual's 2002 compensation, notwithstanding the fact that the individual was not an employee of the plan sponsor in 2002. This violation of the 401(k) plan rules subjects the plan to disqualification, in the event the IRS were to audit the plan and discover the defect. (If the plan is also a profit sharing plan, only the cash-or-deferred-arrangement portion of the plan would be subject to disqualification.) To avoid the severe, adverse effects of disqualification, the plan sponsor should correct the defect by distributing the erroneous deferrals (i.e., the deferrals consisting of 2002 compensation), including related earnings, to the former employee as ordinary income. The employer should reflect these amounts on the former employee's 2002 Form W-2. And, of course, the erroneous deferrals should not be taken into account for purposes of ADP testing, for any plan year. The corrective action described above can be made without IRS supervision or the payment of a fee under the IRS' Self-Correction Program (SCP), which is one of the remedial programs under the Employee Plans Compliance Resolution System (EPCRS). Both the violation and the corrective action should be fully documented in the plan's committee minutes and retained in the plan files. View all Tips © 2010 Reish Luftman Reicher & Cohen, a Professional Corporation Important notice: Answers are provided as general guidance on the subjects covered in the question and are not provided as legal advice to the questioner's situation. Any legal issues should be reviewed by your legal counsel to apply the law to the particular facts of your situation.