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Employer failed to deduct health premiums - now what?


t.haley
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Employee elected health coverage during open enrollment, coverage effective 9-1-21.  Employer just discovered premiums were not being withheld from employee's paycheck.  Can the employer begin deducting the cost of the elected coverage now plus an amount to make up the missed deductions?  Since it was the employer's fault, they want to know whether they can just "eat" the amount of the past-due premiums and begin deducting premiums going forward?  Do they need to issue a corrected W-2 for 2021?

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The employer can treat the premiums it failed to deduct as an employee benefit expense and start deducting now.  The W-2s are correct because the premiums were not deducted.

State law would determine if the missed deductions can be recouped.  There could be some Section 125 plan issues with making the catch-up deductions pre-tax.

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I posted an extensive overview on this very topic.  Copying the relevant part here for reference. 

Approach #3 is the employer "eating" the cost approach you referred to, which I think is fine (and common) as a corrective measure.

https://www.theabdteam.com/blog/correcting-missed-cafeteria-plan-contributions/

Prior-Year Mistakes: Missed Cafeteria Plan Contributions from the Prior Plan Year

Where an employer discovers that it is has inadvertently failed to take the correct elected employee salary reduction contribution amount through payroll in the prior plan year, the employer has three potential options available to correct the mistake:

1. Employee Pre-Tax Contributions in Year Two for Year One Missed Contributions
There is no formal IRS guidance confirming that an employer can take employee pre-tax contributions in year two to address missed contributions for year one. However, we think this is a low-risk approach that is very unlikely to present any issues.

In practice, this is essentially the same approach that employers will commonly apply to address employee pre-tax contributions for a period of leave where the employee is utilizing the catch-up payment option. In that case, employers generally feel comfortable taking an employee pre-tax contribution upon return from leave to cover the full period of the leave—even where that leave straddles two plan years.

Again, although the IRS has not formally approved of that approach, it is a common practice that is generally considered low risk. Note that the pre-pay contribution option is not available to address a period of leave extending to a subsequent plan year because that would violate the Section 125 prohibition of deferral of income rules.

For full details, see:

Furthermore, the employee pre-tax payment in year two approach may also be a good fit to address a situation where the employer discovers a missed contribution error late in year one and wants to spread the repayment over more pay periods than remain available in year one.

Employers utilizing this pre-tax employee contribution option in year two to address missed contributions in year one will want to keep the following issues in mind:

    • Although it is unlikely to present any issues with the IRS, there is no formal guidance approving this approach;
    • If the correction relates to missed FSA contributions from year one, it may require a manual override in year two to exceed the annual limit because payroll systems generally are setup to prevent pre-tax FSA contributions in excess of the applicable annual limit; and
    • Employees may terminate employment in year two prior to the full amount of missed contributions being repaid, which would require the employer to either a) absorb the cost, or b) attempt to seek repayment by check.

Employers should notify employees of this approach in advance so they will be aware of the additional withholding from their payroll in year two to address the retroactive contributions from year one. Employees will have already authorized the full withholding by making the original election to contribute, and therefore employers do not need employees’ approval to proceed with the corrective measure to take the corrective pre-tax contributions in year two.

Sample employee communication: During a recent system audit, we discovered that your [Enter Year] payroll contributions for [Medical/Dental/Vision/FSA/etc.] were underfunded. We will be correcting this error by taking your missed contribution amounts through [an upcoming pay period or upcoming pay periods]. These corrective contributions will be [a one-time or per pay period] amount of [Enter Amount] taken on a pre-tax basis. Please contact People Operations with any questions.

2) Employee After-Tax Contributions in Year Two for Year One Missed Contributions

The more conservative approach would be to require that the employee make the missed year one contributions on an after-tax basis. Employees could make these after-tax contributions in year two through payroll or by direct payment (e.g., check). This approach is of course less advantageous from a tax perspective to both parties.

Where utilizing after-tax payroll contributions, employers should notify employees of this approach in advance so they will be aware of the additional withholding from their payroll in year two to address the retroactive contributions from year one. Employees will have already authorized the full withholding by making the original election to contribute, and therefore employers do not need employees’ approval to proceed with the corrective measure to take the corrective after-tax contributions in year two.

Sample employee communication: During a recent system audit, we discovered that your [Enter Year] payroll contributions for [Medical/Dental/Vision/FSA/etc.] were underfunded. We will be correcting this error by taking your missed contribution amounts through [an upcoming pay period or upcoming pay periods]. These corrective contributions will be [a one-time or per pay period] amount of [Enter Amount] taken on an after-tax basis. Please contact People Operations with any questions.

3) Convert Missed Amounts to Employer Contributions
One final approach is for employers to simply forgive the missed employee contributions without requiring the employee to repay the missed amount. There should not be any issue with taking this approach in a corrective context to address a bona fide employer error. This approach is the costliest for the employer, but also the simplest and least likely to cause employee relations issues related to the mistake.

Under this approach, the affected employees still need to have had the full elected coverage (e.g., premium only plan contributions for medical/dental/vision) or balance available for reimbursement (e.g., health FSA or dependent care FSA) in the prior plan year despite missing some amount of the contributions associated with that election. In other words, this approach is effectively the equivalent of converting the missed employee contributions to employer contributions as a corrective measure—the employer is covering the cost for the amount they failed to withhold from the employee’s paycheck.

Sample employee communication: During a recent system audit, we discovered that your [Enter Year] payroll contributions for [Medical/Dental/Vision/FSA/etc.] were underfunded. We will be correcting this error by forgiving your missed contributions. Despite the error on our end, you still had access to the full benefits you elected for the [Enter Year] plan year. Please contact People Operations with any questions.

Terminated Employees: How to Correct Where Salary Reduction Contributions No Longer Possible

Where employees with missed contributions have already terminated from employment, payroll contributions are no longer an option. Employers could in theory request employees directly repay the missed amounts to the employer (e.g., by check). However, the practical reality is that it is unlikely the employer will ever recover these missed amounts, and therefore the best practice is generally to simply forgive the missed contributions as a corrective employer contribution.

Overcontributions: Returned as Taxable Income

Any amounts that an employer discovers were over-withheld from employees (i.e., salary reduction contributions in excess of the employee’s election) should be returned to employees as standard taxable income subject to withholding and payroll taxes. This may require corrections to the employee’s Form W-2 if discovered after the end of the year.

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