1099-R in this situation?

[Cathy from Chicago]

In 2001, 3 ineligible employees participated in employer's 401(k) and 5 participants had excess deferrals. Both situations were corrected by reissuing 2001 W-2's as discovered in early January, 2002. However, all 8 had earnings on their deferrals (amazing!) so my intention is to issue a 1099 for 2002. Question: is 1099-R to be used, versus 1099-INT? Since I'll only be reporting earnings since the actual excess deferral was 'wiped out' due to revised W-2, are Boxes 1, 2 and 3 of the R coded just with the earnings amount and Box 7 (distribution code) listed as 8? This is my first experience with an excess being corrected via a revised W-2. Thanks in advance.

[ccassetty]

Cathy from Chicago:

For the excess deferrals:

First of all, you will want to make sure that excess deferrals are corrected by refund and reported on 1099-R from now on. That is the only method of correction allowable. Never allow excess deferrals to be corrected via w-2.

You didn't specify exactly how this was handled. Presumably the excess deferrals were "forfeited" and used to reduce the employer's next contributions, and a check for the correct amount was given to the employees as additional pay. As to how to handle the earnings on the excess deferrals after the fact; I think I would be inclined to go back and correct the entire method of reporting the excess deferrals. In other words, instruct the employer to go back and correct the W-2 to reflect the actual deferrals made to the plan, then prepare 1099-R forms reflecting both the deferrals and earnings being distributed. These distributions should show the proper code for making them taxable in 2001 (unless the entire distribution, including earnings totals less than $100). If the earnings were distributed to the employees prior to March 15, 2002, then they should be included with the deferrals on the same 1099-R. If the earnings were distributed after March 15, 2002, then the employer owes the 10% penalty on them and a separate 1099-R would be issued showing the earnings are taxable in 2002. I wouldn't try to go back and actually start transferring money around or cutting new checks to correct this. The excess deferrals and earnings are out of the employees' accounts and the plan is where is should be, so I think correcting the reporting is good enough. But again, it is imperative that the correct method of correction be used from now on.

Ineligible employees:

There are several schools of thought on how to correct ineligibles. The IRS correction method of choice is to amend the plan to bring them in retroactively. Others recommend refunds reflected on either 1099-R or corrected w-2s.

Since the refund method has been chosen by this employer, and the previous refund was reflected on w-2, I see no reason to switch to another method at this point. What I would do is forfeit the earnings in the same manner the deferrals were forfeited and have the employer add them to a corrected W-2 for 2002. If that’s not possible at this point, then I would code them as an excess deferral on a 1099-R.

In this instance it would also be a good idea to document how the ineligibles came to be allowed in the plan and what changes are being made to procedures to make sure it doesn’t happen again.