After tax that should have been pre tax

[Guest mkelly]

An employee elected to defer 5% pre tax. The employer actually withheld it on an after tax basis. This has been going on since 1/1/2001. Can it be corrected for 2001? What about for 2002? Or can it only be corrected from this point forward?

[mbozek]

There are two possible answers: One is that since amounts were included in employees gross income in 2001 and 2002 the amounts are not excludible from taxable income since the amounts were deemed paid to the employee regardless of an agreement to defer the compensation.

The other option is to treat the contributions as pre tax under the theory that the employee never had a legal right to the funds since there was a binding agreement to make a deferral to the 401(k) plan. The inclusion was administrative error for which a revised W-2 can be issued. The precedent is Rev. rul 79-311 where employees who received salary advances from an employer for commissions that were never earned were permitted to return the advances and exclude them from gross income. The employees had a written agreement with the employer that only allowed them to be paid for commissions that were earned.The limitation on this ruling is that it applied to amounts that were returned in the same accounting period for which they were paid although the principle is still applicable -- if the employee has no legal right to the funds that were contributed to the plan because of the binding agreement exclusion was required for 2001 as well for 2002. The questions is whether your tax advisor believes that 79-311 is substantial authority for retroactively changing the after tax to pre tax deferrals.