By DagnyMD, Guest Writer

More and more physicians are pursuing side gigs outside of their main physician job, whether for profit, pleasure, or both. These are typically self-employed endeavors or as a 1099 independent contractor. In addition to the extra income, these provide a fantastic opportunity to utilize a solo or Self-Employed 401(k) (SE401(k)) profit sharing plan that allows you to contribute tax-deferred retirement savings into a qualified account.

Smart move, right? Yes—it’s a great way to increase your tax-deferred retirement contributions and thus to accumulate wealth. The downside is that, unlike an employer plan that has trained administrators watching over it and ensuring compliance with the rules, you are responsible for all that. You wear the hats of the employer, the employee, and the plan administrator. Most physicians have little to no experience with ERISA or IRS rules for retirement plans. Thankfully, that’s where IRS-approved templated plans from large firms like Fidelity or Vanguard are useful. Just fill out the application and adoption agreement to open the account, make your yearly contributions, and file a 5500 or 5500EZ with the IRS each year if assets are greater than $250K. It’s fairly easy and painless to do.

Unless… something happens where you unintentionally didn’t meet a requirement and now your plan is out of compliance. Since you are the plan administrator, that responsibility is yours. Even if you received incorrect information from financial advisors, accountants, or customer service reps, ultimately you are responsible for your plan complying with the rules. But mistakes can and do happen. So what happens if you discover that your self-employed 401(k) is out of compliance? Unfortunately, it’s no longer considered a qualified plan. Translation: the plan is now taxable plus penalties. YIKES! I can tell you from personal experience that when this happens there is a gut-wrenching heavy ball of nausea that takes over as that full realization sinks in. It’s reminiscent of that slow-motion moment in The Christmas Story movie where Ralphie is helping his dad change the tire and sees the pan of nuts flying into the dark—“Oooohhh, F-u-u-u-d-g-g-e!” followed by a sense of impending doom in the deafening silence.


Can You Rescue an Out of Compliance Self-Employed 401(k) Retirement Plan?

So how doomed is your self-employed 401(k) plan? Are taxes and penalties on your hard-earned money and investment gains the only possible outcome? Depending on the what/how of your situation, you may have an opportunity to rescue your SE401(k) qualified status utilizing a Voluntary Correction Program (VCP), which is part of the IRS’s Employee Plans Compliance Resolution System (EPCRS).

A Voluntary Correction Program, or VCP, is an IRS program for self-disclosure of errors in retirement plans. The IRS realizes that errors happen, and that people may be tempted to hide them due to consequences and penalties. The VCP is there to encourage disclosure and correction, in lieu of cover-up and playing the odds that your plan won’t be audited by the IRS. Think of it as an amnesty application, but without a guaranteed outcome. If that worries you, there is an anonymous submission option also. The IRS charges a fee for submitting a VCP, which benefits them by generating revenue from non-compliant plans that otherwise would likely never be uncovered through random audit selection. A win-win: you restore your plan’s qualified status, they collect a fee.

A VCP is one of the three methods the EPCRS offers to correct your plan and protect your qualified status. The others are the Self-Correction Program (SCP) and the Audit Closing Agreement Program (Audit CAP). The self-correction is for minor violations which you correct, then document that correction, and file that documentation with your other plan documents. You do not need to inform the IRS in that scenario. For plan document failures and more significant errors, you would utilize the VCP to receive a compliance statement from the IRS. For errors being corrected during an audit, you negotiate a sanction fee as a component of your Audit CAP.

You may be thinking to yourself, “That wouldn’t happen to me.” Like many physicians, you’re intelligent. You may be a type-A rule follower, and you may also have advisors and accountants assisting you. That was the camp I was in at the time, and I certainly never thought I would find myself in an IRS violation situation. Let me share with you how a few seemingly trivial mishaps resulted in my self-employed 401(k) being at risk.


How My Plan Became Out of Compliance

After residency, I took a job in OB/Gyn private practice. Several of my colleagues would moonlight for the hospital providing back-up for the indigent maternity care CNM clinic, and I decided to as well. Under the guidance of my financial planner and accountant, I applied for an Employer Identification Number (EIN) and opened a self-employed 401(k) at a major financial institution, contributing maximum defined contributions as well as profit sharing. The pay wasn’t much, but I was early in my career so any contribution would have years to grow. After two years, the clinic closed and I didn’t have that source of income. My advisor and accountant both told me I didn’t need to do anything with the SE401(k)—“just let it grow until retirement.”

Seven years later, in the course of moving, I updated my address with my financial institution. I used the convenient “update all accounts” button and didn’t give it a second thought. It wasn’t until many months later I received a letter stating that my SE401(k) account would be frozen for security reasons because a letter had been returned to the financial institution as undeliverable. With a call to customer service, I learned that (Mistake #1) the “update all accounts” only applied to my accounts with my SSN, and not my 401(k) which was under my EIN. I was also informed that the update for that account could only happen with a paper form, not online. They directed me to the correct form to mail in, and I asked if there was anything else I needed to do for that account. The agent told me, “No you are all set, everything is good with your account.” Back on my merry little way I went. It was just a missed address change. And each year both my financial planner and accountant were reviewing all my accounts. It’s all good, right? Wrong.

Fast forward several years to 2020. My current employer‘s 401(k) added a Roth 401(k) option, which also has an in-plan Roth conversion feature. So I decided to rollover my SE401(k) into my employer plan and Roth convert it. I called my financial institution for information and, during this process, the self-employed plan service advisor says “I see you never updated your plan.” (Mistake #2: SE401(k) plan documents need to be updated every 6 years.) “I don’t know what you are talking about” I say. He explains that they mailed me the form for the 2016 update but did not receive it back from me. You’ve probably already connected the dots in this story… that missed mailing years ago due to the EIN address change goof? Yes—that was my plan’s required update notice. “What does this mean? Can I just update it now?” I ask. He tells me, “No, your account is no longer a qualified account. And also, the IRS considers SE401(k) accounts to be terminated plans after contributions stop. You should have closed the account when you stopped doing the self-employed work years ago.” At this point, all the agent would say in response to my many questions was, “You need to talk to your accountant or the IRS about tax implications and next steps.”


My small contributions from years ago are now a very pretty sum. This is where that “Oooohhh, F-u-u-u-d-g-g-e!” moment of overwhelming nausea happened. Fear mixed with outrage and betrayal—after all, I had professionals helping me during the time that these mistakes happened. And as for the financial institution—why was there only one notice for something so important? Why did they say everything was good with the account when it wasn’t, or send a repeat notice to the new address after mail was returned to them, or send a notice in 2016 notifying me immediately of the plan’s loss of qualified status? Who was correct about whether the 401(k) can stay open or should be closed—the financial institution or my financial advisor and accountant? And as for me, why-oh-why hadn’t I read more about SE401(k) plans since I have one? But here I was in this predicament, and I needed to figure out what to do.

I had already “fired my financial planner” so she wasn’t an available resource. The accountant who had been involved had moved into business-only and hadn’t worked with me for several years, but I reached out to her with the situation—she didn’t return my email or call. My current accountant said it was out of his scope. I called multiple accountants and even people in other states who had written articles online about VCP, but none were able to assist with my VCP submission. By now, I had spent countless hours researching, and I determined my main options to be:

  1. File a VCP myself and hope for the best or
  2. Close the SE401(k) and roll into my employer 401(k), file a final 5500, and accept the very low chance that I get audited.


My Ethical Quandry

Here’s where the ethical quandary comes in. Option #1 would be the correct thing to do and, if successful, I could rest easy that I had nothing to fear from a future audit. But despite all my efforts, I hadn’t found a resource to assist in the VCP details and, in typical IRS fashion, parts of the VCP forms and instructions were intimidating and unclear to me. I was concerned about my ignorance accidentally making the situation worse and ending up in a bureaucratic mess with the IRS. Plus it’s a pandemic, so who knew how long a VCP submission could drag on for?

Option #2 would be the incorrect thing to do according to the rules. However, my mistake was an innocent one, without intent to deceive or commit fraud, nor any harm caused. Importantly, the outcome for my money in option #2 would be the same outcome as a successful VCP in Option #1, so the situation is rectified appropriately in both scenarios. The odds of an audit are extremely low, but there would be real consequences if discovered someday.

Maybe you know what you would have done in this scenario. But it was a tough decision for me with some sleepless nights. My partner thought I should just move the money and move on. My accountant told me, “An audit is SO unlikely, especially during these times” which indirectly told me what he thought. Even my church-going “getting caught isn’t what determines right or wrong” mother thought I should just move the money.


Coming Clean with the IRS: Using the Voluntary Correction Program

I changed my mind several times. Ultimately, I decided to keep my integrity intact and come clean to the IRS. That’s what the VCP is for, after all. It is one thing to break the rules unintentionally as I did; it’s another when you know something is incorrect yet do it anyway. And importantly, I really didn’t want my employer 401(k) account tainted forever by nonqualified money mixed in it.

After months of false starts with several accountants and a third-party administrator who knew less about the VCP than I did, I finally found an accountant at a large firm that knew the resource I needed: an ERISA attorney that routinely files VCPs. The attorney submitted my VCP, and we are now waiting in the pandemic backlog for the IRS’s response.

Making a mistake with my SE401(k) and submitting a correction plan to the IRS has been an educational experience and a painful reminder to take personal responsibility for the rules and requirements of my retirement accounts. It’s very humbling to make financial mistakes. If you find yourself in a similar situation with an error in your SE401(k) or other retirement accounts, know that you are not the first nor the last to do so, and there are steps you can take to correct it and protect your tax-deferred qualified status.

Have you filed a VCP in an effort to self-disclose an error with your self-employed retirement plan? How did it resolve? Was it the right thing to do? Comment below!


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