Corrective Distribution (Traditional and Roth Sources)

[Vlad401k]

Let's say the plan failed ADP testing and a participant has both Roth and Traditional sources. If the plan document does not state the order in which the corrective distributions should be done, how would you process the corrective distributions? Would you process it proportionately from each source or would you start with Traditional source first and then do Roth source if the amount exceeds Traditional source.

 

Thank you. 

[Lou S.]

I would ask the ERISA Plan Administrator (usually the Plan Sponsor in same plans) to clarify the method they would like to use. Then document it for future administrative consistency.

[Peter Gulia]

Does anyone deal with a situation in which the plan's administrator allows an affected participant to specify, before a due date, whether her corrective distribution is allocated to non-Roth or Roth?

Is this feasible for a plan that has only a few highly-compensated participants?

(The administrator would set the participant's due date a week or two before the date on which the administrator would instruct the corrective distributions.)

Or even with only a few affected participants, is it too much work?

 

[Below Ground]

When this issue is left as an open administrative function, we typically ask the contact at the firm to have the affected HCE call us for discussion.  In that discussion we outline options and expected impact, directing that person call their tax advisor for counsel and then get back to us with a decision.  Of course, a deadline is set for response, and a follow-up email is sent immediately after the call, covering what was discussed.  If this approach is not allowed by time, or the person fails to get back to us, we discuss the issue with the Plan Administrator and make a decision on default application.  Prorata is probably the safest way in the absence of a decision from the participant.  Another method is in proportion to the contribution division of that person.  We also have plans that are expected to fail send out a "warning notice" to the HCE, asking for them to define their preference.

[Peter Gulia]

Below Ground, thank you for your thoughtful and thorough response, and especially your explanation about ways to set a default allocation.

 

[Luke Bailey]

It seems clear that the IRS does not care which type of contribution you distribute. The LRMs specifically allow you to have Roth first or pre-tax first, as I recall. In theory you could have plan language that would give participant a choice, or, better, have plan language that says employer will adopt a policy, and then have the policy give the participant a choice, but in plans that we have advised where plan sponsor wanted to provide participant-by-participant choice, we have had pushback from bank or mutual fund company recordkeeping plan saying that it was not administrable (e.g., you would need to determine which participants had Roth and get them to make election by 3/15), so we have usually put "pre-tax first" in policy. It's tricky, because on the one hand you could assume most participants would rather get back the money they were taxed on, so that their personal income tax planning for year is not upset, but on the other hand someone who made decision to do part of deferrals as Roth probably viewed that portion of their deferral as having higher future value.

[Below Ground]

Luke, I really like the concept of a formal policy document.  I would suggest that this be given to each HCE right before the testing season begins, under memo saying if this applies to you and you want it done different, then you must submit a written election at this time.  Add an election form to the materials distributed, and all bases are covered, I suggest.  Anyway, if create these materials I would be happy to send to you for your use, since it would be based on your idea.

[Luke Bailey]

Thanks, Below Ground. Appreciate it.