employer coding 401(k) deferrals as after tax on W-2 for one HCE...wha

[Guest DeePA]

We have a take-over plan (those are always the fun ones....ha ha)..

The employer has as 401k provision.

For the one and only HCE the employer has always been coding the deferrals as after-tax. That is, the employee has never received a reduction in federal income due to deferrals. Also the deferrals have never shown up on the W-2.

The plan, however, has always treated them as pre-tax and does not allow after-tax contributions.

The HCE has just retired and needs paid out.

Any ideas on how to handle???

Thanks

Dee

[Mike Preston]

You need to check the 401(k) plan to determine if the plan allowed contributions fromemployees that were not pre-tax. If it didn't, then the only course of action is amend the W-2's and past tax returns to reflect what actually happened. There are likely some changes to the payroll tax returns, as well, that will no doubt make the accountant pull out his/her hair.

If the plan allowed post-tax contributions and these were indeed post-tax contributions and if the plan was properly administered by treating these contributions as post-tax contributions (unlikely, but, hey, gotta allow for the possibility) including the appropriate ACP test (post-tax contributuions and matching contributions are tested together), then there really isn't anything to be done.

What other options are there?

[mbozek]

Recharacterizing the AT contributions as pre tax will result in double taxation for the ee because the S/l for refunds is only 3 years so tax returns prior to 99 cant be changed. Employer/ plan admin would be liable for paying extra tax. If the contributions are left as AT then the ee will not pay tax on the distribution. Better to amend the plan to permit AT contributions and recharacterize contributions from 99 as pre tax and have ee file amended tax return based upon revised w-2. Another option is to amend plan and treat all ee contributions as after tax to conform to W-2.

[Guest DeePA]

MBozak-

You suggest amend plan to allow for aftertax..

can i really retroactively amend back to say 1995???

I would think not since it's way past corrective amend period...

[mbozek]

Whether you can correct under the rules of 401(B) is not at issue- The plan has a problem in that it has AT money which has to be paid to the part. Amending the plan is the only way to conform to the treating of the AT contributions as they were remitted. The amendment is subject to audit risk. Not changing the plan means that the amounts must be treated as pre tax contributions which requires that the participant be taxed on the funds again. If the er does not want to take a risk in revising the plan for AT contributions then treat the ee contributions as pre tax and gross up the ee for amount of the tax due on the contributions. But it will cost a lot of money if the HCE made contributions over a long period. If the employer wants to pay, it can ask the IRS for approval of the change to permit AT contributions under a correction progam. The Q is how much risk is the sponsor willing to take. The less risk the more it will cost to fix the problem. Before you select an option, ask who pay to correct the mistake? The employer, the plan advisor, the TPA, the payroll service?

[Mike Preston]

I seriously have my doubts that amending the plan to make the deferrals be treated as after-tax will work. First, the employee probably (hopefully?) signed a salary deferral election. Making that an after-tax contribution election seems difficult at this stage. Second, assuming you can get the IRS to go along with recharacterizing the deferral as after-tax, you would still be subject to the ACP test on these monies. If there was no match then the only ACP monies would be the HCE's and all of it would need to be disgorged. Very thorny. Yes, takeovers are fun.

[jpod]

I agree with Mike Preston. The contributions were either pre-tax or post-tax; there's no "fix" here via a plan amendment.

If they were pre-tax, for years for which the applicable SOL has expired, the employee has a problem, and if he has a problem that may become someone else's problem too (e.g., the employer, the payroll service . . . ). Unfortunately, that's the way the cookie will crumble.

The best advice at this time is to hurray up and fix the W-2s and 941s before another SOL expires.

[Blinky the 3-eyed Fish]

I too agree with Mike. This is now only an issue between the HCE and his personal taxes. It's really no different than if I missed that deduction I could have taken years ago. CRAP! A hard lesson in paying attention will surely be learned.

[Guest DeePA]

Blinky/Mike-

Are you saying that upon paying out this person, you are okay calling it aftertax money and not making him pay tax on it again at distribution time?

Or are you saying..too bad..he missed the deduction back then and he's taxed on it at distribution time?

Dee

[Blinky the 3-eyed Fish]

You can't call it after-tax because it would have had to been legitimately after-tax and passed the appropriate testing. In short, too bad.

[mbozek]

Blinky : the failure to treat the ee contributions as after tax for the purpose of tax reporting is the employer/TPAs problem not the employee's problem because the employer is responsible for correctly filing a W-2. If the funds were logged as pre tax for plan purposes then they should not have been included as taxable wages. Therefore if the employee must pay tax on the AT contributions upon distribution the employer will be liable for the taxes (unless the plan admin is tagged for failure to administer the plan). What needs to be answered is how does the employee think the contributions were made- pre or after tax? By the way was ADP testing preformed? or were there no 5% owners.

It is not an issue of missing a deduction- it is paying a tax on income twice because of a failure to properly record the contributions. Based upon prior experience if the employer has to choose between audit risk for retroactively amending the plan to permit AT contributions or paying the taxes incurred by the employee for the AT contribution the employer will amend the plan.

There is also an elephant in the room: since the plan admin is a fiduciary to the employee I think there is a duty to tell the employee of the problem so that the employee can consult his own tax advisor.

[Everett Moreland]

As to the statute of limitations, the mitigations provisions, IRC §§ 1311-1314, might help. As to whether the contributions are pre- or after-tax, the definitions of elective and employee contributions in 1.401(k)-1(a)(2)(i) and (g)(4) and 1.401(m)-1(f)(6) give some weight to whether the employer reports the contributions as pre- or after-tax.

[Blinky the 3-eyed Fish]

The phrasing that this is the one and only HCE. leads me to believe he is the owner. So, if that is the case it is his error any way you slice it. If not, then he does have an issue to work out with the employer and the employer may have an issue with their payroll company. What I don't think is involved is the plan in any correction. The plan was administered properly from what I gather, it's the payroll that was improperly reported.

My comments of too bad were based on him being the owner. Also, my deduction comments would be a similar situation in which too much tax is being paid.

[jpod]

EXTREMELY doubtful that the mitigation provisions would apply, because I do not think the "same item" of income would be taxed twice within the meaning of those provisions. But it's worth a try. The problem, however, is that the mitigation provisions could not be tested until the individual received distributions from the plan. He'd have to report part of the distribution as nontaxable; then, if the IRS disagreed and determined that they were taxable, he and the IRS would have to explore the mitigation provisions to see if they could be applied to his benefit. By that time, any claim for damages which the individual would have against the employer or someone else may have expired.

The way I see it, the individual has an excellent claim for damages against the employer for misreporting his contributions on the W-2s, at least for the years for which the SOL has already expired. If the individual is an owner and does not wish to "sue himself," and if there is no other party who could be liable, well that's just a tough break.

[imchipbrown]

Were these contributions to a separate account? Perhaps you can argue that these weren't contributions under the Plan (mis-titled account, should have been taxable). Taxes should have been paid for gains and deductions taken for losses in the ensuing years, but statute years are closed, and good chance losses could be beneficial.

Since after tax, should be plenty of basis when distributed.

Totally a devil's advocate view, but....

[Mike Preston]

No way is my firm continuing to provide services to the plan if they opt for a retroactive amendment along with audit risk, without submission under EPCRS.

One thing that should be looked into before too many (more?) tears are shed on this thing is how did the HCE have his taxes completed? Is it possible that he told his accountant: "Oh, the W-2 is wrong, just use $xx,xxx as a 401(k) deferral when you complete my tax return." Yes, the IRS should have bounced the returns if they didn't match the W-2's. But I've seen stranger things.

Well, I can hope, anyway.