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Impermissible Distribution

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We processed a distribution of a participant's account in full (mistakenly thinking we had a distributable event). Now we need to correct the error. Is an impermissible distribution of a participant's full account considered an overpayment in EPCRS? I am trying to figure out how to correct the error and the overpayment correction is the only area I can find that seems to apply to our situation.

Thanks.

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Also, as a follow-up question: what do we do if the participant is unable or unwilling to return the money that was distributed to them?

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We processed a distribution of a participant's account in full (mistakenly thinking we had a distributable event). Now we need to correct the error. Is an impermissible distribution of a participant's full account considered an overpayment in EPCRS? I am trying to figure out how to correct the error and the overpayment correction is the only area I can find that seems to apply to our situation.

Thanks.

Did you ever find an answer to this?

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A payment in excess of what the participant or beneficiary is entitled to receive is an overpayment under EPCRS. Rev. Proc. 2008-50 has correction methods for overpayments. Of course, you will have to determine which program you are under; SCP, VCP, etc. The easiest way to find information is to search the Rev-Proc for "overpayment".

Rev. Proc. 2008-50, Section 5.01(3)© Overpayment. The term “Overpayment” means a Qualification Failure due to a payment being made to a participant or beneficiary that exceeds the amount payable to the participant or beneficiary under the terms of the plan or that exceeds a limitation provided in the Code or regulations. Overpayments include both payments from a defined benefit plan and payments from a defined contribution plan (either not made from the participant's or beneficiary's account under the plan or not permitted to be paid either under the terms of the plan or under the Code or regulations). However, an Overpayment does not include a payment that is made pursuant to a correction method provided under this revenue procedure for a different Qualification Failure. Overpayments must be corrected in accordance with section 6.06(3).
Rev. Proc. 2008-50, Section 6.06(3) Correction of Overpayment failures. An Overpayment from a defined benefit plan is corrected in accordance with the rules in section 2.04(1) of Appendix B. An Overpayment from a defined contribution plan is corrected in accordance with the Return of Overpayment method set forth in this paragraph. Under this method, the employer takes reasonable steps to have the Overpayment, plus appropriate interest from the date of the distribution to the date of the repayment, returned by the participant or beneficiary to the plan. To the extent the amount returned to a defined contribution plan is less than the Overpayment adjusted for earnings at the plan's earnings rate, then the employer or another person must contribute the difference to the plan. The Overpayment, adjusted for earnings at the plan's earnings rate to the date of the repayment, is to be placed in an unallocated account, as described in section 6.06(2), to be used to reduce employer contributions (other than elective deferrals) in the current year and succeeding year(s) (or if the amount would have been allocated to other eligible employees who were in the plan for the year of the failure if the failure had not occurred, then that amount is reallocated to the other eligible employees in accordance with the plan's allocation formula). In addition, the employer must notify the employee that the Overpayment was not eligible for favorable tax treatment accorded to distributions from Qualified Plans (and, specifically, was not eligible for tax-free rollover).

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What I'd really like to know is whether an impermissible distribution (e.g., a distribution when the participant is not entitled to one) is an "Overpayment". As you noted, an Overpayment is generally defined as payment in excess of the amount payable. If a participant isn't entitled to a distribution, would any payment be in excess of the amount payable (which technically is zero) and thus be an Overpayment or does an Overpayment occur only when they receive more than they should have?

The method of correcting an Overpayment under EPCRS would require the employer to reimburse the plan when collection efforts fail. This seems like an unreasonable correction method when a participant receives their entire account balance (and not a penny more), but just received it prematurely.

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I don't see how an impermissible distribution could be anything other than an overpayment. The payment was $X. The participant was entitled to receive a distribution of $0 under the terms of the plan. That makes the entire $X payment an overpayment.

If the participant doesn't repay the distribution the correction still may not be a big deal. That is, unless the employer doesn't want to contribute to the plan. The corrective deposit is used for employer contributions. We had this happen last year. A client had an employee who became legal and got a valid social security number. Without telling us what they were doing, they terminated him on their payroll under the old SSN and rehired him under the new SSN. He received a distribution while still employed before we found out what they were doing. Of course, the participant did not repay the distribution. As stated in the second quote in my prior post, the corrective deposit was held in an unallocated account and used towards their profit sharing contribution. They contributed the same amount they intended to contribute, they just designated part of it as the corrective deposit. Note, the participant's account did not get restored. All in all, the correction was fairly painless.

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When you go in under VCP, you might think about citing DOL Advisory Opinion 77-32A. I've included an excerpt below - see that last paragraph of the excerpt, particularly the sentence I've underlined. While this was probably considered more in a DB context, it seems applicable for a DC if all "reasonable" attempts for repayment have been unsuccessful.

..."For discussion purposes, we are dividing the first ruling requested into three questions:

A. If a participant or beneficiary fails to repay an erroneous payment he received from the Fund, may the unpaid amount due from him as reimbursement be offset against any plan benefits due to or for the participant or beneficiary until the Fund is repaid in full?

B. If a participant or beneficiary fails to repay an erroneous payment he received from the Fund, may his eligibility for plan benefits be terminated until the amount due is repaid in full?

C. If a participant or beneficiary fails to furnish information requested by the Fund which is pertinent to the Fund’s operations, may the Fund delay payment of any benefits or may the participant’s or beneficiary’s eligibility for plan benefits be terminated until the information is supplied?

With respect to question A, we note that in accordance with section 404(a)(1)(B) of ERISA, a fiduciary must attempt, with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims, to collect money owed to the plan, including recovery of erroneous payments made from a plan. We believe that, depending on the facts and circumstances relating to each erroneous payment, reducing future benefits payable by a fund to a participant or beneficiary, in accordance with the provisions of the plan, may be prudent if other reasonable attempts to collect the erroneous amount have failed. In this regard, payment of the erroneous amount to the participant or beneficiary may be viewed at an advance payment of benefits due him under the plan.

"...

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It seems from the wording 6.06(3) that when the Overpayment is returned to the plan, whether returned by the participant or returned by the employer, the returned Overpayment goes into an unallocated account, used to reduce future contributions. In this case, of an improper distribution of a participant directed account, the return by the participant of the funds to an unallocated account seems to defy logic.

So, my question is, if the participant returns any or all of the impermissable distribution of his own account (the exact amount distributed = 100% of his account), should that amount returned by the participant be put back into the participant's own account or into an unallocated account?

"The Overpayment, adjusted for earnings at the plan's earnings rate to the date of the repayment, is to be placed in an unallocated account, as described in section 6.06(2), to be used to reduce employer contributions (other than elective deferrals) in the current year and succeeding year(s) (or if the amount would have been allocated to other eligible employees who were in the plan for the year of the failure if the failure had not occurred, then that amount is reallocated to the other eligible employees in accordance with the plan's allocation formula)."

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The wording could be better, but I think you have to interpret it along with the general correction principle that you put the plan back to where it would have been if the error had not occurred. So, if the Employer repays the distribution, it goes into an unallocated account for use towards employer contributions. If the Employee repays an amount that rightfully belongs to him, but was not eligible for distribution, it goes back in his account. If he is repaying an amount distributed that should not have been part of his account balance, then it goes to the unallocated account or gets reallocated to the other participants.

For example, if an in-service distribution is paid from my balance when I'm not eligible to receive it and I repay the distribution, it should go back in my account.

But, if my balance is $1,000, I get paid $1,200 and repay the $200, the $200 goes to the unallocated account or gets reallocated.

At least, that's how I see it.

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We have a situation very similar to this one, so I will continue with this thread rather than starting a new one.

We have a 401(k) plan that allows for in-service distributions, but they allowed an under 59 1/2 participant to

take an in-service distribution of his 401(k) source money. Participant has spent the $35,000 distribution and

can not repay.

We want to correct this through EPCRS. Is there any chance the IRS would call this failure anything other than

"Overpayment"? I don't see what else it could be.

The plan has not had any employer contributions for several years and the employer does not want to put the $35,000

back into the plan, as no employer contributions are being done.

On EPCRS submission, If we propose that the participant repay the Overpayment using a repayment schedule; does anyone

think that might fly?

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If a participant pays the distribution back after the close of the tax year, does that create basis in the account, with only earnings on the returned amount subject to tax on subsequent (ostensibly correctly-timed this time) distribution?

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Richard,

The only times I've had an agent question the type of failure is when they are trying to claim you don't qualify for the program you want to use. Other than that, they have only been concerned about the correction method.

You never know what the IRS will do. Under VCP, you can always ask. You might get to correct the way you want. I've seen a wide variation in the knowledge level of the agents processing these filings. That makes it pretty much impossible to predict what the IRS will do.

BG,

My opinion is that repayment with after-tax $ gives them a basis and repayment with pre-tax $ does not.

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I think this is an area where even the IRS is confused. I think it is an overpayment under EPCRS and has to be corrected with the method stated in the Rev. Proc.

The American Benefits Council apparently agrees and wrote a letter to the IRS regarding these type of overpayments back in 2010 askng for a change to EPCRS...

http://www.appwp.org/documents/epcrs_comme...etter041610.pdf

Here is that part of that letter....

The Council believes that the repayment requirement where, notwithstanding the employer’s reasonable steps, the employee does not repay the overpayment is too punitive in some circumstances. In many situations, for example, where the employer is making ongoing employer contributions, the repayment requirement is essentially meaningless. The employer would have made the same contribution regardless of the overpayment failure and the repayment is merely a formality. In contrast, however, correction where a plan does not have ongoing employer contributions may be punitive. The employer or plan service provider would be obligated to make a corrective contribution equal to the amount of the overpayment plus interest. This contribution could not, however, be used to offset future contributions, and it is far from clear how the corrective contribution may be used other than through a windfall allocation to participants. This may arise, for example, in a plan that solely provides for elective deferrals or in a plan that is frozen. For these reasons, the Council suggests that the repayment requirement be eliminated. It has virtually no significance in contexts where there are employer contributions against which the corrective contribution may be offset, and it is punitive in contexts where there are no ongoing contributions. We appreciate that a correction that merely involves notice that the distribution is not eligible for rollover and reasonable efforts to secure repayment may strike some at Treasury and the Service as too gentle. However, the current system is untenable and we see few palatable alternatives. It is better to err on the side of fairness than to create an arbitrary and punitive correction method simply to deter potentially abusive behavior, i.e., systematically disregarding the in-service distribution restrictions. This is particularly true given the existing protections in EPCRS which make the program unavailable for egregious failures.

Interestingly, however, Avaneesh Bhagat, Program Coordinator for the Employee Plans Voluntary Compliance stated in a phone forum that he didn't think a corrective employer contribution was neccessary in such a situation.

http://www.irsvideos.gov/EPCRS

The next category of issues deals with broadly improper distributions, and we'll illustrate one scenario but really it could be anything. Here you have a situation where the distribution was made to an employee because it was thought that the employee terminated employment with the employer. However, it turns out that the employee did not sever from employment and the employee simply transferred from one employer in the control group to another. So really what you have is a distribution that was made from an employee's account balance in violation of plan terms.

What causes confusion in this area often is that a distribution that's made in violation of plan terms falls within the revenue procedure's definition of overpayments, which generally deals with the erroneous distribution of excess amounts to a participant. So within the overpayment correction you have two issues: one, that distributions that were made from an employee's account balance in violation of plan terms; and another, which is the more common one, a distribution made to an employee that was in excess of what an employee was entitled to under the terms of the plan.

Under both of those scenarios, whether it's a distribution from account balance in violation of plan terms or an excess amount distributed to the participant, you would take the following step. The employer would make a reasonable attempt to recover amounts distributed. The employer would in effect notify the employee of the erroneous distribution and ask for the money back. It would also inform the employee that unreturned monies are not eligible for tax favored treatment such as a rollover to an IRA.

However, there is a distinction, though. If you have an erroneous distribution made from a participant's account attempting to recover monies from the participant is fine, but the employer wouldn't be required to make a corrective contribution to the plan to replenish amounts that weren't returned by the employee because the employee would get a windfall. That correction piece is generally limited to situations where excess amounts were distributed to an employee which would in effect have an impact on what other employees are entitled to. In that case the employer would then be expected to replenish the plan for unrecovered monies so that other affected employees could get what they're rightfully entitled to.

That provision is not really very clear in the revenue procedure so oftentimes when you have a situation where an improper distribution is made from an employee's account that question often comes up, is the employer stuck with making corrective contributions to the plan to the extent that the employer's not successful in recovering monies from the employee? The answer to that is no, because you don't want to create a windfall situation for that employee

What you propose as a correction seems reasonable but maybe an informal call before a submission would be wise. I also agree that it would create basis if paid back with after-tax dollars.

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I'm attempting to revise an old post with two additional questions.  Participant of a 401(k) Plan and current employee requested and received an impermissible distribution that was transferred directly to an IRA 2 years ago.  Participant received a 1099-R reporting is as a rollover back in 2016.  The Plan discovered the error and are self correcting by treating this as an Overpayment requesting the amount plus earnings be deposited back into his account.  The Participant has agreed to return the funds.   He will receive a 1099-R this year from the IRA custodian reporting the rollover back into the Plan.   Does anyone see an issue with correcting this way and does the Plan have to file an amended 1099-R for 2016 because it was impermissible distribution?

Thank you!

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Madison, I might think about passing on issuing the 2016 corrective 1099-R because it was a rollover in any case with no tax consequences to the participant.  His IRA's sending money back now to the Plan is a lucky occurrence and will be a plan to plan transfer probably with no 1099-R.  Not all IRAs would send the money back.  Even if the IRA issues a current year 1099-R to report the rollover back to the plan it won't hurt the participant either as it will be another nontaxable rollover to a qualified plan.  But if you issue a corrective 2016 1099-R, it might require the participant to file an amended 2016 tax return and explain all the back and forth; I don't know for sure.  Are you prepared to hire an accountant to prepare an amended 2016 tax return for this participant?

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Sounds like no harm/no foul on the reporting end and trying to fix that reporting would cause a whole 'nother set of problems worse than the first one, which is being corrected.

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