Withholding at option of participant allowed?

[Belgarath]

This question is an oddball, so be gentle! Suppose you have a corrective distribution from a 401(k) plan - calendar year 2003 plan. Let's say excess contributions under an ADP failure. These are not eligible rollover distributions. Let's further suppose that the distribution is made in January of 2004 - within 2-1/2 months after the correction period, so it isn't taxable in 2004.

My interpretation is that 10% withholding does not apply.

First, do you agree? And assuming you do, the question was - MUST the Plan Administrator allow the participant the option to elect withholding at 10% or even more than 10% if the participant wants to? My interpretation would be no.

Moving on to a somewhat related question - suppose you have a non-periodic IRA distribution, to which 10% withholding applies unless the participant elects out of it. Is an IRA custodian REQUIRED to allow the participant to elect additional withholding? I don't find anything in the regs to require this, although I may have missed it, and I know that many custodians do allow this - of course if required, then they probably all do! The W4-P has a line to elect additional withholding, but I'm not sure if additional withholding option is required for all IRA distributions.

Appreciate all opinions. I just hate these fiddling little questions.

[TBob]

With regard to the first part of your question, I agree that the 10% doesn't apply. Since the distribution within the first 2 1/2 months is taxable in the prior year, you can't withold in the current year for the prior year.

[Appleby]

This question is an oddball, so be gentle! Suppose you have a corrective distribution from a 401(k) plan - calendar year 2003 plan. Let's say excess contributions under an ADP failure. These are not eligible rollover distributions. Let's further suppose that the distribution is made in January of 2004 - within 2-1/2 months after the correction period, so it isn't taxable in 2004.

My interpretation is that 10% withholding does not apply.

First, do you agree? And assuming you do, the question was - MUST the Plan Administrator allow the participant the option to elect withholding at 10% or even more than 10% if the participant wants to? My interpretation would be no.

.

The 10-percent would not apply to the excess, but would apply to any earnings…

Moving on to a somewhat related question - suppose you have a non-periodic IRA distribution, to which 10% withholding applies unless the participant elects out of it. Is an IRA custodian REQUIRED to allow the participant to elect additional withholding? I don't find anything in the regs to require this, although I may have missed it, and I know that many custodians do allow this - of course if required, then they probably all do! The W4-P has a line to elect additional withholding, but I'm not sure if additional withholding option is required for all IRA distributions.

Appreciate all opinions. I just hate these fiddling little questions .

It seems the only requirement is to provide the option to elect out of the 10-percent. OTOH…IRC § 3405(e)(8) says that 100% can be withheld…wouldn’t this suggest that the option should be given?…especially when one considers the penalties that could apply under the estimated tax rules if the withholding and estimated tax payments are not sufficient.

[Harwood]

Belgarath: I agree re: question one. Also, the employer should not allow optional withholding in 2004 that relates to taxable income from 2003.

From Form 1099-R Instructions:

"Excess contributions distributed within the 2 1/2-month period are not subject to Federal income tax withholding or social security and Medicare taxes. But amounts distributed from a 401(k) plan after the 21/2-month period are subject to Federal income tax withholding under section 3405."

Appleby: I disagree on the earnings. If paid within 2 1/2 months, they are taxable in the prior year and not subject to any withholding.

All: don't forget the under $100 exception - all taxable in current year.

[Belgarath]

Thanks for the responses. Appleby - what does OTOH mean?

As far as the 3405(e)(8), I interpret that to mean that you don't have to withhold more than the available cash. Example - account balance of 30,000, of which 15,000 is a loan. Participant elects to roll over 14,000 in cash, and will receive a deemed distribution/offset on 15,000 outstanding loan, and will receive 1,000 cash distribution, for a total of 16,000. The 20% withholding would ordinarily be 3,200, but since 100% of the cash distribution is less than the 20%, then only 1,000 is withheld.

On all of this gobbledygook, I'm inclined to think it is safer to just allow withholding, but I'm trying to determine if mandatory, and I'm not completely confident that I'm thinking through it correctly. And if there's no definitive guidance, then I definitely agree with you that the conservative approach is more prudent.

[Belgarath]

Harwood - thanks. I also just located the following from IRS Notice 87-77 - this is presumably the source for the W-2 instructions. (I never thought of checking them - could have saved myself some time!)

Notice 87-77, I.R.B. 1987-51, 9, December 21, 1987.

In the case of a 401(k) plan distributing excess contributions and income earned thereon within the first 21/2 months after the close of the 1987 plan year, the payor or plan administrator

must report the amount of 1987 excess contributions and income earned thereon in Box 9 and Box 10 on 1988 Form W-2P with a Code P in Box 14 or, in the case of a total distribution, on

1988 Form 1099-R in Box 1 and Box 2 with a Code P in Box 7. These amounts are not subject to FICA taxes and are not subject to income tax withholding.

So I feel reasonably confident that on the 401(k) situation, you don't have to allow the participant any withholding option. But I'm still not sure on the IRA...

[Harwood]

Belgarath: Form W-2P hasn't been around since about 1991, so proceed cautiously with using that 1987 Notice

[Belgarath]

Good point!!

[Harwood]

Re: question two:

I think that the IRA custodian must honor requests for additional withholding, if requested on Form W-4P

[Appleby]

Appleby: I disagree on the earnings. If paid within 2 1/2 months, they are taxable in the prior year and not subject to any withholding.

Harwood, help me out here.

I know that the excess amount is not subject to withholding if distributed within 2 ½ months…but isn’t that treatment limited to the excess amount and not the earnings thereon? If not, what am I missing? On the treatment of the distribution of elective deferrals Rev Proc 92-93 says “The withholding requirements of section 3405 of the Code apply to the portion of the distribution that is includible in income”.

[Harwood]

Rev Proc 92-93 is dealing with deferrals and match being distributed due to 415 violations. The wording you quote is matched in the 1099-R instructions for "Excess Annual Additions Under Section 415": "Such distributions are not eligible rollover distributions although they are subject to Federal income tax withholding under section 3405."

For ADP and ACP corrective distributions, the ERISA Outline Book states: "The allocable earnings distributed with the excess contributions under the ADP test or with the excess aggregate contributions under the ACP test are taxed in the same year as the excess amount is taxed . . ."

[Appleby]

I think we agree on when the amount would be taxed. What we appear to disagree about is whether the withholding rules apply to the amount. Let’s separate the two issues. Unless you are saying that because it is taxed in the previous year 3405 does not apply ??? which I do not think is the case …

Note that I am not saying that you are wrong…but...

At first, I also thought Rev Proc 92-93 only addressed 415 excess amounts. However, it also says…

“The distribution of elective deferrals pursuant to section 1.415-6(b)(6)(iv) is a corrective disbursement rather than a distribution of accrued benefits. Thus, it is analogous to distributions under sections 401(k)(8) (distribution of excess contributions), 401(m)(6) (distribution of excess aggregate contributions), and 402(g) (distributions of excess deferrals).”….

Therefore, Rev Proc 92-93 appears to include amounts that are excess deferrals due to failure of nondiscrimination testing. agreed?

From the instructions for filing 1099-R and 5498

“To determine your withholding requirements for any designated distribution under section 3405, you must first determine whether the distribution is an eligible rollover distribution. See Direct Rollovers on page R-2 for a discussion of eligible rollover distributions. If the distribution is not an eligible rollover distribution, the rules for periodic payments or nonperiodic distributions apply. For purposes of withholding, distributions from any IRA are not eligible rollover distributions. “

Do you still think the withholding does not apply?

[Appleby]

Using the 415 approach…

From ….

Panel Pension Library Deluxe

Panel Answer Books

401(k) Answer Book - 2004 Edition

Chapter 8 — Contribution Limits

Code Section 415—Annual Addition Limits

Q 8:42 What are the tax implications of elective contributions that are returned to a participant to correct a Section 415 violation?

The tax consequences of returned elective contributions are as follows:

1. The distribution is includible in income for the taxable year distributed.

2. The distribution …

3. The distribution …

4. The distribution is not …

5. No consent ….

6. The distribution is subject to voluntary withholding under Code Section 3405. Thus, it is not considered an eligible rollover distribution. 7. The returned elective ….

[Treas. Reg. § 1.415-6(b)(6)(iv); Rev. Proc. 92-93, 1992-2 C.B. 505]

Some text deleted for copyright reasons.

[Harwood]

Four types of corrective distributions. Four sets of instructions with Form 1099-R:

Corrective distributions of excess deferrals are not subject to Federal income tax withholding or social security and Medicare taxes.

Excess contributions distributed within the 2 1/2 month period are not subject to Federal income tax withholding or social security and Medicare taxes. But amounts distributed from a 401(k) plan after the 2 1/2 month period are subject to Federal income tax withholding under section 3405.

A [excess aggregate contribution] distribution made within 2 1/2 months after the close of the plan year is not subject to Federal income tax withholding or social security and Medicare taxes. But amounts distributed after 2 1/2 months are subject to Federal income tax withholding under section 3405.

Such [Excess Annual Additions Under Section 415] distributions are not eligible rollover distributions although they are subject to Federal income tax withholding under section 3405. They are not subject to social security, Medicare, or Federal Unemployment Tax Act (FUTA) taxes. In addition, such distributions are not subject to the 10% early distribution tax under section 72(t).