This question relates to the recharacterization of Pre-Tax Deferrals to After-Tax Contributions to correct an ADP test violation. Please disregard catch-up contributions for purposes of this discussion. Treas. Reg. Section 1.401(k)-2(b)(3)(ii) states that recharacterized excess contributions will be includible in the HCE's taxable income "as if such amounts were distributed" under the regulations applicable to distributions of excess ADP amounts. When excess ADP amounts are distributed from the Plan to correct an ADP test failure, the employee is taxed on the net amount of the excess, after adjustment for earnings or losses.
Surely, these regulations cannot be saying that the same occurs upon recharacterization (note that the recharacterization regulation does not specifically refer to earnings or losses, although the regulation relating to the distribution of excess contributions does include a discussion of earnings and losses). If we truly were to recharacterize the full amount of what would otherwise be distributable, then the earnings on th excess contributions would be taxable to the employee and so would become after-tax in the plan, and the employee would have additional basis because of the earnings on the excess contribution. As you know, earnings on after-tax contributions are not taxable to an employee until distributed. So, why would recharacterization result in a different conclusion than if the amounts originally had been contributed as after-tax contributions? Therefore, I believe that this regulation must be interpreted to mean that the recharacterized amount (and so the taxable amount) must equal the amount of the actual excess contribution, as adjusted for losses but NOT adjusted for earnings (because if those contributions originally had been after-tax contributions, the earnings would have remained in a "pre-tax" source).
Any thoughts either way?
Recharacterization Under Final 401(k) Regulations
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