401(k) Audits: What You Need to Know

There are many benefits to offering a 401(k) plan. For starters, 401(k) plans are critical to attracting and retaining qualified people. They also help employees prepare for retirement.

But did you know that, as a plan sponsor, you might be required to conduct a 401(k) audit?

Read on to learn about 401(k) audits, including what they are, who must conduct them (and when), what they involve, and how to prepare for one.

What is a 401(k) audit and what are the requirements?

A 401(k) audit is an annual review of an employer’s 401(k) plan by an Independent Qualified Public Accountant (IQPA). The audit verifies whether the plan is complying with requirements administered by the Internal Revenue Service (IRS) and the Department of Labor (DOL).

These requirements relate to:

• Establishing the 401(k) plan — e.g., plan document, trust to hold the plan’s assets, and record keeping system.
• Operating the 401(k) plan — e.g., participant eligibility, contribution and compensation limits, withholding pretax and after-tax contributions, remitting employee contributions, required minimum distributions, Form 5500 filing, and nondiscrimination testing.

However, a 401(k) plan isn’t necessarily subject to an independent audit just because it must adhere to IRS and DOL rules. Whether the plan must undergo an audit comes down to the audit requirements of the Employee Retirement Income Security Act (ERISA).

Whether the plan must undergo an audit comes down to the audit requirements of the Employee Retirement Income Security Act (ERISA).

Note that ERISA is a federal law that sets minimum standards for most private-sector health and retirement plans. ERISA is enforced by the IRS, the DOL, and the Pension Benefit Guaranty Corporation.

Is your 401(k) plan subject to ERISA audit requirements?

Generally, if a 401(k) plan is covered by ERISA and has 100 or more eligible participants at the start of the plan year, then it is considered a “large” plan and must be audited by an IQPA.

This means 401(k) plans with fewer than 100 participants at the beginning of the plan year generally do not need to undergo external 401(k) audits.

Although the general threshold is 100 or more eligible participants, there are some exceptions.

What are the exceptions to the 100-participant threshold?

There are 2 primary exceptions to the 100-participant rule. One pertains to a “short plan year,” and the other to the “80-120 rule.”

Short (or partial) plan year

If your plan year lasts 7 months or less, you can postpone the audit to the next plan year. This doesn’t prevent the audit — it only delays it.

Additionally, if the number of eligible participants falls below 100 in the next plan year, then you must undergo an audit as a “small” plan for the short/partial plan year.

Note that 401(k) plan sponsors must use Form 5500 to fulfill their reporting requirements under ERISA and the Internal Revenue Code. Plan sponsors file Form 5500 annually through the ERISA Filing Acceptance System II (EFAST2).

During a 401(k) audit, the IQPA audits the plan’s financial statements and then prepares a report, which the plan sponsor must attach when filing their Form 5500.

So, if you postpone the audit to the next plan year, you will need to perform 2 independent audits: 1 for the short plan year and 1 for the (current) full plan year.

You must also attach the 2 audit reports to the same Form 5500 you are filing for the (current) full plan year.

The 80-120 rule

This means your 401(k) plan does not need to undergo an independent audit if it has between 80 and 120 eligible participants and had a “small” plan status in the previous tax year.

For example, if the plan had 90 eligible participants in Plan Year 1 and 100 in Plan Year 2, you do not need to conduct an audit for either year.

So long as the number of eligible participants stays at 120 or less, you are not required to have an audit. But if the number rises to more than 120, then you must audit the plan through an IQPA.

When must plan sponsors audit their 401(k) plan?

Plan sponsors must complete the audit 7 months after the end of the month in which the plan year ends.

For instance, if the plan year ends on December 31, you must have the plan audited (and submit the audit report with your Form 5500) by July 31 of the following year.

Form 5500 filers can apply for a one-time extension of up to 2 ½ months. If this extension is granted, then the audit report’s due date would be extended as well.

What’s involved in a 401(k) audit?

A 401(k) audit focuses on 2 main areas: compliance and financial reporting.

Compliance verifies whether the plan is operating in accordance with IRS and DOL regulations and the plan document.

Financial reporting determines the accuracy of the plan’s financial statements as well as the information reported on Form 5500.

Documents the IQPA will likely need to review include the following:

• Prior years’ and current year’s Form 5500 filings
• Plan document, including amendments
• IRS determination letter for the plan document
• Summary plan description, including any modifications
• Agreements with 401(k) providers
• Record keeping reports
• Trust reports
• Plan activity, such as distributions, loans, etc.
• Contributions placed into the trust
• SOC report revealing the internal processes of 3rd-party providers (e.g., record keepers or trustees)
• Employee census data
• Proof of fidelity bond protecting the plan against losses caused by fraudulent or dishonest actions
• Prior years’ audit reports, if applicable
• Other important correspondence or agreements relevant to the plan

Tips for employers to prepare for a 401(k) audit

Below are steps you can take to help ensure a smooth 401(k) audit process.

• Choose an experienced and reputable IQPA. Not all CPAs specialize in 401(k) audits, so make sure you select one that specializes in this area.
• Gather and organize the necessary documents. Work with your 3rd-party administrator (if applicable) to assemble the necessary documents, as requested by the IQPA. See the previous section for some of the documents you’ll likely need to provide.
• Use integrated HR/payroll software to increase speed and accuracy. An integrated HR tool makes it easier to obtain your 401(k) records for the audit, plus helps ensure the information is correct.

It’s also important to know the common types of 401(k) plan errors, so you can avoid them.

Common 401(k) plan errors include:

• Failure to compare the plan document’s eligibility requirements with actual eligibility practices
• Also, failure to compare the plan document’s definition of “compensation” with actual payroll practices
• Failure to deposit participants’ contributions on time

Keep in mind, the independent audit is a legal requirement, which means plan sponsors can be penalized for missing the audit.

Don’t wait for the audit to identify 401(k) issues

It’s important to do your own internal 401(k) audits, prior to the external audit, so that you can uncover any issues that could result in noncompliance.

If you skip this step, you risk the IQPA  finding problems that could jeopardize the plan’s tax-qualified status. The IQPA may also uncover additional compliance issues that could lead to other penalties.

You will likely have an opportunity to correct issues found during the audit. An experienced IQPA can help you develop an action plan for fixing these problems, plus offer guidance on how to prevent them in the future.

You may be able to rectify the issues through voluntary correction programs offered by the IRS and DOL.

With that being said, it’s best to minimize audit risks by ensuring your 401(k) internal processes are in top shape, and planning ahead.