ESOPs Benefits & Compensation – Q1 2025 Client Alert | Kaufman & Canoles

Happy Spring from the Kaufman & Canoles ESOPs, Benefits & Compensation team! We hope you’re shaking off the winter blues and ready for another round of benefits updates.

IRS Provides Guidance on New Roth Catch-Up Rules

Following a two-year delay by the IRS, the SECURE 2.0 mandatory Roth catch-up rules are slated to take effect in 2026. The IRS recently released proposed regulations explaining how those rules will work and answering many open questions.

As a brief reminder, the new rules require that employees who were paid over $145,000 from the employer in the prior year can only make catch-up contributions in the current year as after-tax Roth contributions, not pre-tax contributions. While the rule is seemingly simple, it raises several technical issues that necessitated the delay. The proposed regulations generally resolve those open items.

Under the proposed regulations:

• Plans can either allow a separate catch-up election for impacted employees or allow a “spillover” design in which the employee can contribute the maximum amount (including catch-ups) and the catch-up portion can be automatically contributed as Roth. If a plan uses the latter, it would need to allow the participant to cut off Roth catch-up contributions.
• Roth contributions made at any time during the year can be used toward the Roth catch-up requirement. In other words, the Roth contributions don’t need to be the last dollars contributed to the plan during the year to qualify for the mandatory Roth catch-up.
• If any impacted employee can make Roth catch-up contributions, then all employees must have the ability to make Roth catch-up contributions. This means Roth catch-up contributions cannot be limited to the highly paid impacted employees.
• The calculation of an employee’s prior-year compensation is broadly based on the employee’s FICA wages, which could be different from the plan’s regular definition of compensation and may need to be tracked separately.
• If the plan does not allow any Roth contributions, it will not be required to add them, but impacted employees would not be able to make any catch-up contributions.

Employers should work with their recordkeepers and third-party administrators to make sure all parties are prepared to implement these rules shortly.

DOL Allows Limited Self-Correction for Late Deferral Deposits

Several years after originally floating the idea, the Department of Labor (“DOL”) will now allow retirement plan sponsors to self-correct late deposits of employee elective deferrals or employee plan loan repayments. Late deposits arise when an employer withholds elective 401(k) deferrals or plan loan repayments from an employee’s paycheck but fails to deposit the withheld amount into the plan within a reasonable time (in most cases, a few days). In the past, the only option to fully correct late deposits was to submit a correction request to the DOL through its Voluntary Fiduciary Correction Program (“VFCP”) and wait for affirmative approval from the DOL, a lengthy and often cumbersome process that caused many plan sponsors to informally self-correct instead of using the formal VFCP procedures.

As of March 2025, plan sponsors may now self-correct late deposits. However, as is often the case, progress comes slowly: The DOL’s self-correction alternative contains several requirements that make it less user friendly than it may at first appear. For example:

• Self-correction can only be used if the lost interest on the late deposits is $1,000 or less.
• Late deposits can only be self-corrected within 180 days of the payroll date from which they were withheld, meaning late deposits discovered on an annual plan audit generally will not be eligible for self-correction.
• The employer is still required to complete and retain documentation regarding the correction, then file it with the DOL electronically, so the amount of work involved often will not be reduced.
• The late deposit must still be reported on the Form 5500 filed for the plan year in which it occurred.
• Excise taxes still need to be paid to the plan.

These requirements are far more burdensome than the comparable self-correction process under the IRS’s correction program, which generally only requires the plan sponsor to correct the error and keep documentation of the process.

It’s too early to tell how often this option will be used, but it may be a good fit for employers with small late deposits that are discovered quickly and who would like some measure of compliance certainty.

ESOP Cash Investment Cases Pose Risk for Sponsors

After a decade and a half of the DOL’s practice of regulation through litigation, the employee stock ownership plan (“ESOP”) community received some promising developments with the potential of changing the direction of the DOL’s ESOP enforcement program. The recent upheaval in the federal government and the appointment of a new Secretary of Labor familiar with ESOPs both bring optimism for change. However, the private plaintiffs’ bar has broadened its scope to include several lawsuits filed against ESOP fiduciaries alleging a failure to prudently invest cash held in the ESOP trust. These claims represent a significant and novel shift from ESOP practice and prior class action suits.

In one illustrative case, Schultz v. Aerotech, the plaintiffs argued that Aerotech’s ESOP held nearly 20% of its total plan assets in cash equivalents, yielding a return of less than 1.5% over five years. Aerotech countered that the cash-heavy approach was necessary to meet future ESOP repurchase obligations. The plaintiffs, however, claimed Aerotech could have pursued higher-yield investments while maintaining adequate liquidity.

The court reviewing Aerotech’s motion to dismiss pointed to the “vast disparity” between Aerotech’s cash-heavy approach and the practices of similar plans as raising an inference that Aerotech failed to meet its fiduciary obligations under ERISA. While ESOP sponsors might be able to demonstrate that their investment strategy was justified under their specific circumstances, the allegations of imprudence were enough for the case to survive a motion to dismiss, which often leads to costly discovery.

While Schultz v. Aerotech is just one example of this new wave of litigation, these cases could signal a potential trend. ESOP fiduciaries are encouraged take note. Despite the reality that most ESOPs do not usually maintain such a “cash heavy” plan asset ratio as the Aerotech ESOP trust’s 20% cash position, it is important that ESOP fiduciaries always be mindful of the cash vs. company stock ratio and make reasoned decisions as to the investment directions for any cash and cash equivalent plan assets. If an ESOP does have cash or cash equivalent plan assets, it is highly advisable that an investment policy statement be adopted that will guide the investment of such plan assets in accordance with the proper use and intent of such plan assets over the near-, medium-, and long-term. Finally, in instances where ESOPs find themselves with “cash buildup” without a proper near-term need for liquidation (such as current year ESOP distributions or diversifications), ESOP fiduciaries should consider engaging an investment advisor or investment manager for the investment of such cash or cash equivalent plan assets.