How to Calculate Lost Earnings in a 401(k)

Calculating lost earnings in a 401(k) plan involves determining the hypothetical investment gains a retirement account would have accumulated had an administrative error not occurred. These errors might include a missed contribution or incorrect investment of funds. The calculation aims to restore the participant’s account to its correct value, encompassing both the principal and the investment growth it should have achieved.

Understanding Lost Earnings

Lost earnings represent the financial difference between what a 401(k) account should have earned and what it actually earned due to an administrative oversight. The objective is to “make the participant whole,” placing them in the same financial position they would have been in had the error not occurred. This ensures participants do not suffer financial detriment from plan administration issues. Lost earnings are essentially a calculated estimate of the earnings that would have been realized if the contribution was properly calculated and funded to the employee’s account at the original date.

These calculations arise when correcting administrative errors. The employer or plan administrator is responsible for rectifying these errors and compensating for any lost earnings, covering missed investment returns.

Common Scenarios Requiring Calculation

Several common administrative errors necessitate the calculation of lost earnings in a 401(k) plan. One frequent issue involves delayed or missed employee contributions, where amounts withheld from an employee’s pay are not deposited into their 401(k) account in a timely manner. Similarly, delayed or missed employer matching contributions, which are promised but not timely deposited, also lead to lost earnings. These situations mean that funds that should have been invested were not, thus missing out on potential growth.

Another scenario involves the incorrect investment of contributions, such as when funds are placed in a default, low-performing fund instead of the participant’s chosen allocation. Errors in processing rollovers or transfers can also result in a period where funds remain uninvested. Furthermore, using an incorrect definition of compensation can lead to under-contributions for employees, requiring a corrective contribution along with lost earnings.

Information and Resources for Calculation

Gathering specific information and documents is necessary before calculating lost earnings. You will need:
Error date: This is when the contribution should have been made or the incorrect investment occurred.
Correction date: This is when the error was identified or rectified, defining the period of loss.
Exact dollar amount: This is the sum improperly handled, whether it was a missed contribution or an amount incorrectly invested.
Hypothetical investment performance: This refers to the historical rate of return for the fund the money should have been invested in.
Actual investment performance: If the money was invested incorrectly, this is the performance of the fund it was placed in.

This data can be found on 401(k) statements, through plan administrator records, or investment fund websites. The Department of Labor’s (DOL) Voluntary Fiduciary Correction Program (VFCP) offers an online calculator for certain corrections.

Core Principles of Calculation

The calculation of lost 401(k) earnings is built upon several fundamental financial and mathematical concepts. A central idea is the “but-for” principle, which aims to determine what the account value would have been if the error had not occurred. This principle ensures the calculation reflects the true impact of the mistake on the participant’s retirement savings. The power of compounding is another significant factor, as investment returns can generate further returns over time, greatly magnifying the impact of lost earnings over an extended period.

An appropriate rate of return must be applied for the period of loss. The Internal Revenue Service’s (IRS) Employee Plans Compliance Resolution System (EPCRS) generally prefers using the actual earnings based on the participant’s investment choices. If this is not feasible, reasonable estimates or alternative methods may be used, such as the plan’s actual rate of return for non-participant-directed plans, or for participant-directed plans, the highest-performing fund available to the participant during the period.

The calculation covers a specific duration, spanning from the error date to the correction date. Compounding interest is typically used for 401(k) calculations because it accurately reflects how investments grow. Lost earnings calculations must include any gains the funds would have accrued, and in some cases, may be adjusted for losses, with specific exceptions.

Step-by-Step Calculation Process

Calculating lost earnings in a 401(k) involves several methodical steps to determine the exact amount owed. First, identify the specific dollar amount subject to the error, such as a missed contribution or an incorrectly invested sum. Next, determine the precise period of loss by identifying the error date and the correction date. This timeframe is critical for accurately assessing the missed growth.

You must then identify the hypothetical investment option where the money should have been placed. This refers to the specific fund or allocation the participant elected, or if no election was made, the plan’s default investment. Obtain the historical performance data for that specific investment over the period of loss, which provides the actual rate of return the funds would have earned. The IRS’s EPCRS offers guidance for calculating these earnings adjustments, generally favoring actual earnings based on participant choices. If actual earnings calculation is impractical, reasonable estimates or alternative methods are permissible.

Once this data is gathered, calculate how much the initial amount would have grown if it had been invested correctly, including the effect of compounding. The DOL provides an online calculator, frequently used for corrections under its Voluntary Fiduciary Correction Program (VFCP), which computes compounded lost earnings. If the money was invested incorrectly, subtract any actual earnings it did accrue from the hypothetical earnings. The resulting figure represents the total lost earnings. Spreadsheets or financial calculators can aid in these complex computations.

Example: Missed Contribution

An employee’s $1,000 contribution due on January 1, 2024, was not deposited until July 1, 2025. If the money should have been invested in an S&P 500 index fund, and that fund returned 15% in 2024 and 7% from January 1 to July 1, 2025:
Hypothetical value: $1,000 (1 + 0.15) (1 + 0.07) = $1,230.50
Lost earnings: $1,230.50 – $1,000 = $230.50

Example: Incorrect Investment

Suppose $5,000 was mistakenly placed in a money market fund on January 1, 2024, instead of the intended growth fund. The error was corrected on January 1, 2025.
If the growth fund returned 12% during that year, the hypothetical value would be $5,000 (1 + 0.12) = $5,600.
If the money market fund returned 2%, the actual value would be $5,000 (1 + 0.02) = $5,100.
Lost earnings: $5,600 – $5,100 = $500.