When 401(k) plans go bad: avoiding disqualification

By Maha Ahmed, Azzad qualified plan financial consultant Business owners who sponsor 401(k) plans understand the favorable tax benefits these plans can provide. But the benefits come at a cost. Employers must follow strict Internal Revenue Service (IRS) and Department of Labor rules. Those who don’t can find themselves in hot water. A 401(k) plan is said to be “qualified” when it complies with tax rules and is therefore entitled to its favorable tax status. But plans that run afoul of the rules (for example, by improperly excluding participants, missing contributions, or failing discrimination tests) can become “disqualified.” The potential tax effects of plan disqualification are severe. These include having to pay taxes on contributions and earnings you thought were tax-free or even tax-deductible and even losing the ability to roll over plan assets. Even worse, a plan may be disqualified retroactively if the plan defect occurred in a prior year. This means you would likely need to file amended returns to reflect the tax effects of disqualification for those prior years. Penalties for under reporting income in those prior years could also be imposed. And while the IRS generally can’t go back more than three years (six years if