If you have a customized 401(k) plan, you may have been a regular pen pal with the IRS. The documents of a qualified retirement plan, like a 401(k), must comply with the Internal Revenue Code. That means a plan must not only operate according to IRS rules, but the plan documents themselves must meet all IRS requirements. When they do, you’ll receive an IRS determination letter as proof.
So how does a company that is considering to offer a qualified retirement plan ensure that their new 401(k) will comply with IRS rules? As with many things in the 401(k) world, it depends. One way to get that sense of assurance is to adopt a pre-approved plan. This is typically a plan offered by a third party such as a financial institution or 401(k) specialist. In this case, the provider has already gained approval from IRS for the plan documents, so the plan sponsor can confidently adopt this type of plan.
If the plan sponsor wants more flexibility than a pre-approved plan provides, the sponsor can adopt an “individually designed plan.” Such a plan might be created by an attorney or other third party. In this case, it is the plan sponsor who must ask for dispensation from the IRS. Once the IRS reviews the plan documents and finds them compliant, it will issue an IRS “determination letter” to the plan sponsor. The letter is a formal acknowledgement that the plan meets ERISA criteria. If the plan falls short in some way, the IRS will list those issues along with actions necessary to bring the plan into compliance.
Keeping in touch with the IRS
There are no regulations that require individually designed plans to receive a determination letter. But 401(k) plan sponsors have traditionally relied upon these letters as “proof” the plan does in fact have tax-qualified status. Without a determination letter, the plan could be at risk that an IRS audit would yield a nasty surprise. In fact, plan sponsors wanted regular assurance that their plan documents remained in compliance. The IRS has provided this assurance by allowing plans to apply for a new determination letter every five years.
But in 2016, the IRS decided to end this regular correspondence with plan sponsors. Effective January 1, 2017, the IRS no longer allows determination letters for ongoing individually designed plans. The agency will continue to provide determination letters for new plans, but it will not reconfirm the tax-qualified status of existing plans subsequent to the initial determination letter, except in the event of plan termination. The IRS has blamed a lack of resources, in part, for this decision.
So, what’s a plan sponsor to do? Auditors and other third parties often require that individually designed plans provide them with a determination letter. But going forward, plans will have to take another approach. One solution might be to hire an ERISA expert to periodically review the plan and provide an opinion on its tax-qualified status. Another option could be to convert to a pre-approved plan.
But what about other plans?
Not every employer opts for a customized plan. Many companies opt for a pre-approved plan, particular smaller employers. Subsequent to recent IRS rule changes, there now are two categories of pre-approved plans: “standardized” and “non-standardized.” When the IRS approves these plans, the designer (perhaps a law firm or financial company) receives an “opinion letter” from the agency. The employer then relies on the third party’s opinion letter as confirmation of the tax-qualified status of their plan documents.
Standardized vs. non-standardized plans
A company adopting a standardized plan is generally required to select from pre-approved options and adopt the plan word for word. It is possible for a sponsor to make some minor changes, but these include adopting certain amendments the IRS publishes pertaining to standardized plans. The idea is, the employer selects a pre-approved plan off the shelf as is.
These standardized plans come with rules regarding who can be excluded from the plan, as well as some predefined formulas governing contributions. If this sounds familiar, it’s because standardized plans are a type of safe harbor plan, and as such, automatically pass certain discrimination tests.
Non-standardized plans provide a bit more flexibility. A company could select a safe harbor version of the plan that doesn’t require testing, or it could choose a more flexible plan where testing would be required. The employer itself has limited ability to alter the plan without losing the protection of the opinion letter.
However, the determination letter lives on if the employer wants to make minor changes to a non-standardized plan. This requires the employer to file IRS Form 5307 and obtain its own determination letter.
The IRS decision to stop providing determination letters is a big deal for individually designed plans. Plan sponsors will either have to live with more uncertainty or convert to one of the pre-approved plans.