Tax reporting of refunded contributions

[GBurns]

A 401(k) fails testing and contributions (for whatever reason) long after the end of the calendar and plan year and also after W2s have been issued and all employees have already filed their tax returns. it is determined that monies have to be returned to the participants.

How and when is this returned amount taxed?

How, when and where is it reported?

An additional factor is that the employer would like to pay for the employees ant taxes due.

How can this be done?

[bzorc]

Well, assuming your plan year was 12/31/01 and the refunds are being made now, the refunds (the contributions plus related earnings/losses) will be reported on the individual's 2002 tax returns. They will get a 2002 Form 1099-R reporting the distribution, with a code "8", indicating a refund of contributions taxable in 2002. Also, since its past 3/15/02, the employer will have to file a Form 5330 reporting the late refunds and pay a 10% excise tax on the total amount of contributions refunded to the participants.

As far as the taxes due go, that can't be determined until the individuals prepare their 2002 personal returns. To figure out the additional taxes due on the behalf of each participant, depending on the number of participant's affected, will be burdensome.

Hope this helps.

[GBurns]

Thank you very much.

What happens if it was not past 3/15/02?

[Archimage]

Then the participant would owe the taxes for 2001 tax year and the employer would not owe the excise tax.

[bzorc]

The participants affected would need to amend their 2001 returns to report the refund. In this instance, the employer would now have a better idea of how much additional tax each person would have to pay, if they were still interested in paying the liability for the people.

[GBurns]

If the employer pays the tax liability, how is that reported?

[pjkoehler]

GBurns: Any amount that the employer pays the employees in 2002 to defray their increased 2001 personal tax liability due to the corrective distributions will be includible in their gross income (subject to withholding as supplemental income), treated as "wages" for FICA/FUTA purposes and reported accordingly on the employees' 2002 W-2. Thus, if the employer wants to make each employee whole, it will have to determine the appropriate "gross up" amount per individual.

[Guest planman]

I agree with all that said so far. I have a related tax question since this happened to our plan and we issued refunds after 3/15/02 for the 2001 plan year. Some people were required to forfeit matching contributions on refunded contributions. Some of these people also terminated and already rolled over their total distribution before we finished testing and refunds. We instructed these people to get the refund amount from the rollover institution since its not eligible anymore and also get the forfeit amount and give it back to us. We will correct the 1099R for the rollover eligible amount and refund. We may not be able to get the forfeiture amount back though. If the employees keep the forfeiture, we expect to tax them. Should this be taxed with a 1099R from the plan or somehow taxed from the employer? The employee has the relationship with the rollover institution and we do not intend to deal with them directly.

[pjkoehler]

planman: Your basic approach sounds ok. I gather your plan required that the nonvested excess match (caused by the corrective distribution of excess contributions) provided some procedure for their ultimate reallocation to the accounts of the remaining participants. It can be argued that these amounts constitute "plan assets" and the fiduciary (probably the plan administrator/employer in this case) that incorrectly computed the amount payable and directed the trustee to distribute the excess amounts caused the plan to sustain a loss, with respect to which the fiduciary is liable to restore. Now, of course, the trustee could undertake a collection action against the participants, but that's almost certainly not a cost-effective (i.e. not a reasonable) exercise of discretion. If the nonvested excess matching would have been held in a suspense account and, together, with the income thereon, simply used to reduce the matching contribution for next year, this is probably a no harm no foul situation so long as the employer makes the full match next year. You might want to take a quick look at the DOL's voluntary fiduciary correction program as well.

As far as the correct withholding and reporting procedure, you should consider that the noneligible rollover distributions are not only includible in gross income for both and state and federal income tax purposes, but constitute "wages" for FICA/FUTA and probably any state employment tax (SDI, etc.) The employer's payroll system is better designed to properly compute and report these amounts than the trust's reporting system. So, one approach would be to have the employer make up the loss and put the plan back in the position it would have been in and then run the excess amounts through its payroll system, impacting the 2002 W-2.

[GBurns]

Let us say that for practical reasons the employer cannot recover from most and wants to get rid of the issue by picking up the amounts and the associated taxes for the employees and ex-employees.

How is this reported? Where is the income and the taxes reported on 941 and W2 etc?

[pjkoehler]

GBurns: Let the employer make up the noneligible rollover contributions as a corrective contribution to the plan, taking the position that it thereby assumed the legal status of obligee with respect to the terminated employees' debt. It could go through the motions of making a demand on the participants for repayment, but ultimately characterize the amounts as compensation due to forgiveness of debt applying the same reporting and withholding treatment as a forgiven employer loan, i.e. supplemental income.