Ineligible 401k participant

[Guest Ed Walker]

HR allowed an employee to begin deferring July 1, 2001.--They are not eligible until January 1, 2002.

As I read the rules the fix is to retro amend to include the ineligible employee.

Can I amend to include this employee by name or do I need to come up with some objective measurement to bring them in?

[Guest UKH]

Rev Proc 2001-17 allows you to retroactively amend your document. However when you retroactively amend the document you can not favor an employee. In your case the employee who came in as of July 1, 2001. When you retroactively amend your eligibility or plan entry date you will have to follow it for all employees. This could lead to another problem. You may have to put in a QNEC for those employees who were not given the option to defer in the beginning. However by retroactively changing the eligibility, the employer just opens the door wider.

[Guest Ed Walker]

Can we return the employee's contribution and reissue the w2?

OR

This is one of 2 employees hired in July 2000. Do you think we can amend to make all employees who satisify 1 year of service in July 2001 eligible immediately?:confused:

[Guest UKH]

Yes you can return the ineligible contributions to the individual and reissue his W-2.

If the employer does not want to return the participant's ineligible contributions then the only way he can allow the participant to keep his/her deferrals in the plan is by retroactively amending the plan document. By doing so you will have to allow the other participant also who would have met the eligibility based on the retroactive eligibility requirements. Depending how much QNEC the employer would have to make for the participant who was not offered the option to participate in the plan will be the deciding factor for the employer to choose one of the two methods.

Both correction options will fix your problem.

[wmyer]

Another fix would be to distribute the salary deferral from the plan, make it taxable for 2002, issue a 1099-R for 2002 by 1/31/2003, and forfeit any match the participant was given.

[maverick]

wmyer:

I have heard of your method, but wonder what code you'd use to report the distrib. Since you don't want the non-participant to pay the 10% early dist penalty, would you report it as a code 7? Thanks. Maverick

[wmyer]

Yes, maverick, I'd use code 7.

[Guest KevinP]

wmyer, do you distribute any gains that would have been earned on the deferred amount? What about losses, can the participant take a credit on their tax return for any losses they might have incurred?

Thanks.

[wmyer]

I am not a tax expert, but here's what I think -- distribute the salary deferral amount at market value. If there are gains, the entire amount of the distribution is taxable in the year of distribution. If there are losses, the participant is also taxed only on the amount distributed. For example, the participant deferred $1,000 in 2000 and had income of $50,000 less $1,000 deferred. He's only taxed on $49,000 at the federal level in 2000, even though he was not eligible for the 401k plan. Now in 2001, let's say his account is only worth $800. So he's going to get a 1099-R for $800, which is the amount he will pay taxes on for 2001. However, let me emphasize again that I am not a tax expert. So take my response for what it's worth. Maybe someone out there who is a tax expert should respond to this question.

[Fredman]

If correcting per wmyer's method, I wouldn't use a 7 as the distribution code. That labels the distribution as normal, which in my book means the participant is over age 59.5.

I think an 8 (excess contributions taxable in current year) would be more suitable in this situation.

[Mike Preston]

ukh: I'm not sure I agree with your interpretation of RP 2001-17. The relevant cite, in Appendix B, Section 2.07 is:

"This paragraph does not apply unless (i) the amendment satisfies section 401(a) at the time it is adopted, (ii) the amendment would have satisfied section 401(a) had the amendment been adopted at the earlier time when it is effective, and (iii) the employees affected by the amendment are predominantly nonhighly compensated employees. "

In the case of an amendment that lowers the eligibility criteria solely for a given participant, it seems the IRS will approve if that individual is an NHCE and the amendment could have been made at the earlier time when it is effective. So, while there might be some 410(B) and 401(a)(4) implications of such an amendment, they may not be fatal.

[lkpittman]

Mike--I agree with you. I would like to know if anyone has submitted such an amendment (retroactive amendment to permit inclusion of ineligible employee--permitting only erroneously included employee to participate) with any luck or problems?

Thanks.:confused: