Ineligible employee allowed to make deferrals

[Guest jefe96]

Plan has first of plan year and 7th month entry dates. Participant completed 1 yos after 7/1 but was allowed to make deferrals for the remaining part of the year. The document says to distribute the deferrals, plus earnings, back to the participant. Question is how is this treated for tax purposes? Should they receive a 1099 for this amount? When do they include this in income? It's not a rollover eligible distribution, so should it just be done in the same manner as an excess deferral?

[Guest smstls]

Assuming this is a 2004 correction , the deferrals and earnings will be paid to the participant and a revised 2004 W2 will be sent. No 1099 is issued. Also, you should probably notify the participant that the revised W2 is coming so that they can wait before completing their tax return.

[Harwood]

If the Plan document says to distribute the deferrals, plus earnings, then this would be reported on a 1099-R.

[Guest mmc]

I have the same situation. Do we report it on a W2 or 1099?

[Jim Chad]

I think Harwood said it right. You can't report earnings on a w-2. You would use a 1099r to report distributions to correct every form of paying an amount over the legal limit. This is one of them.

Since this 1099 will be issued in January of 2006 and use a cope P to report it taxable in 2004, you might want to warn the employee to report the income now on his 2004 tax return so he will not need to amend his return. We do this with a letter and we suggest he give the letter to his tax preparer. This seems to work well for us.

[Harwood]

An abbreviated summary of some of the options:

If the document deals with the issue, report disgorgement on a 1099. [An early version of the Corbel GUST document had an "Inclusion of Ineligible Employee" clause but it did not make it to the IRS approved version].

If the document is silent, forfeitures need to occur and the employee will "have to be made whole outside the plan."

IRS correction procedures suggests you amend the plan to let the person into the plan early so that the money stays in their account.

Of course some employers do a negative 401(k) deduction, but this option is definitely not available once a calendar year-end has occurred.