Payroll withholding continued after loan was paid off

[Trekker]

Participant took a loan from the plan. Repayments were by payroll withholding. Loan was paid off as scheduled in August of 2007. Now we find out that withholding continued bi-weekly for several months to the tune of $10,000, which was deposited into plan each pay period.

Aside from the obvious question of why the participant did not notice that amounts were being withheld each pay period, what should be done about it now?

Any thoughts will be appreciated.

[GBurns]

It is not obvious. The employee has had this same deduction coming out for many months (probably even 2 years or more) and has become accustomed to it. Unless they get a monthly statement showing the loan balance, I do not expect any employee to notice for quite a while.

What is more obvious to me is Why did the administrator (or the system) not see the initial $0 loan balance, then for many months not see the overage balance on the loan account?

Where in the Plan did the money go ?

If any ADP or other periodic tests were done, Did the discrepancy not show up ?

I blame the administrator and the system, not the employee.

[Guest Sieve]

I think this is a classic "mistake of fact" situation. It was incorrectly assumed that the loan was not paid off when the funds went into the plan in 2007, and that fact was incorrect. If the plan has "mistake of fact" language, then the funds should be returned to the employer and then paid to the employee as 2008 compensation. Earnings would stay in the employee's account.

[jpod]

While I agree that it should be a mistake of fact, IRS is very rigid on definition "mistake of fact." Absent some authority that is directly on point, no need to take any risk here.

1. Employer repays employee on a tax-free basis, and the repayments are not reported on a W-2 (because the loan withholdings were already taxed).

2. Take the money plus earnings (but not minus any losses) out of the participant's account and use it to reduce future employer contributions to the plan or pay plan expenses.

If employer doesn't like these two steps because of the cash flow differential, let it know that it's taking a risk on the "mistake of fact" theory. IRS and DOL won't be too sympathetic about employer's cash flow issues because the over-withholding was it's fault in the first place.

[Guest mjb]

I think this is a classic "mistake of fact" situation. It was incorrectly assumed that the loan was not paid off when the funds went into the plan in 2007, and that fact was incorrect. If the plan has "mistake of fact" language, then the funds should be returned to the employer and then paid to the employee as 2008 compensation. Earnings would stay in the employee's account.

Since the plan was never entitled to excess funds in the first place, the employee must receive earnings as well as the payment, because the excess was never eligible to be a plan asset. Even if the plan does not have a refund feature the funds must be returned to the participant because the plan has no legal right to retain excess payments. Why should the excess payments be paid as compensation when they were an after tax payment to the plan? The only taxable amount are the earnings on the excess payments. The employer may refund the excess payment and interest to the employee and offset the excess payment made to the plan against future contributions if the plan permits such a procedure and the payments do not exceed the deduction limits under the IRC.

[Trekker]

GBurns - you are right. It is not the employee's fault.

We had also thought of Jpod's suggestion and will probably go with something very much like that.

Thanks for your responses!