Improper Distributions

[Guest Gordy]

A participant needed money to pay his disorderly conduct fine. He calls the broker to "tap into" his 401(k) account. "No problem", says the broker, "how much do you need?". "$1,500" is the answer. "Checks in the mail" says the broker.

So, the first employee gets a check from the mutual fund company payable to the participant. Before the employer finds out about this there are five employees with eight distributions. (Word of a good thing spreads quickly and if one distribution is good, two is better). All this happened in the last 6 months and it's a calendar year plan.

The document has no provision for loans or early distributions. I've waded throught Rev Proc 2003-44 and am not 100% comfortable with how this should be handled. Example 21 references hardship distributions and retroactive amendment. Also the criteria used by the employer for the hardship distributions was in accordance with regs. Do you think a plan amendment only for the period January 1, 2003 to October 27, 2003 (when this was caught) allowing distribution based on age would work? There was no disclosure paperwork no tax withholding either.

Oh, did I mention that one employee got all funds, including employer, in which he was only partially vested? Of course, he has since terminated emplyment.

[E as in ERISA]

Did you ask the broker and/or mutual fund company to restore the loss to the plan?

[Guest gcrechale]

we recently had a very similar situation--the participant was distributed his account balance with no type of distributable event occurring. his monies were in a segregated account. it is our understanding that if he is unable to pay the money back into the plan, which looks like the case here, the employer must put the money back into his account to make the plan whole. then his original 1099r for 2003 will be voided and reissued showing $0 taxable.

we understand most of the thinking about this, but it does not make sense to us that the participant is going to be getting a tax free distribution in 2003 and will be able to get the same amount out at a later date when a distributable event does occur. it would make more sense to us for the employer to have to put the money back into the plan and allocate it among all the participants. any thoughts on this??

[TBob]

gcrechale - In situations like this in the past, we have always started with asking the participant to refund the money. It is not an easy thing to get them to agree but you might get lucky. We have also always operated under the correction principal of putting the plan back in the position that it would have been in, had the error not occurred. An impermissible distribution is a operational defect and we would apply the appropriate self correction program.

In the past couple of years we have stopped putting money back into the participants account if they would refuse to refund it themselves. It was our understanding that the IRS had agreed with your thinking that the participant should not get a windfall out of the situation because of the error. I unfortunately, have no back up for this reasoning and can't quote any speaker from an ASPA conference or IRS notice, etc. that blessed this method.

We would simply ask for the money back and if it did not come back by the end of the year, we would tax report it on a 1099Misc rather than a 1099R. The reasoning here is that the distribution, since it was not based on a distributable event from a qualified plan, should not be reported as a distribution from a qualified plan. Again, no back up for this method but it seemed reasonable to us.

For what it's worth, that's how we handled these situations. I would like to hear from others to tell me if we were way off base or not!