How to tax/pay returned employee contributions?

[ERISAatty]

A client has a non-ERISA, employee contribution only 403(b) plan that become frozen effective 1/1/09.

The employer forwarded on the employee contributions of four employees to a particular fund and these checks reached the fund custodian after 1/1/09. The fund custodian responded that, due to the freeze, they had a "hard deadline" and could not accept the contributions after 12/31/08 (so the money never got into the 403(b) Plan, per se).

Checks have been returned to the employer.

I advised employer that the returned money should be returned to employees and 'taxed accordingly.'

Now client's payroll department wants details on whether 'taxed accordingly' means to pay through payroll and tax in '09, or whether W-2C's must be issued with respect to '08 (the latter answer would make client grumpy, not that I'm too worried about that).

I'm not expert in this area, but is the right answer that the employer can simply pay the money through payroll in '09 (imposing tax in '09), and just needs to issue a 1099-R (by 1/31/10)?

This is not an 'excess distribution,' as I understand it, because no 402(g) or 415, etc. limits have been surpassed, but it seems to make sense to return the amount as if it were an excess distribution (but without any excise tax, etc). Therefore, I have looked at Rev. Proc. 2008-50, Section 6.06(1) ["Treatment of Excess Amounts"], which refers, in turn, to Rev. Proc. 92-93 (which is where I saw the 1099-R reference).

I believe that's correct, but I bet somebody on the boards knows for sure.

Can you confirm (or redirect me?)

Thanks!!

[Guest mjb]

A client has a non-ERISA, employee contribution only 403(b) plan that become frozen effective 1/1/09.

The employer forwarded on the employee contributions of four employees to a particular fund and these checks reached the fund custodian after 1/1/09. The fund custodian responded that, due to the freeze, they had a "hard deadline" and could not accept the contributions after 12/31/08 (so the money never got into the 403(b) Plan, per se).

Checks have been returned to the employer.

I advised employer that the returned money should be returned to employees and 'taxed accordingly.'

Now client's payroll department wants details on whether 'taxed accordingly' means to pay through payroll and tax in '09, or whether W-2C's must be issued with respect to '08 (the latter answer would make client grumpy, not that I'm too worried about that).

I'm not expert in this area, but is the right answer that the employer can simply pay the money through payroll in '09 (imposing tax in '09), and just needs to issue a 1099-R (by 1/31/10)?

This is not an 'excess distribution,' as I understand it, because no 402(g) or 415, etc. limits have been surpassed, but it seems to make sense to return the amount as if it were an excess distribution (but without any excise tax, etc). Therefore, I have looked at Rev. Proc. 2008-50, Section 6.06(1) ["Treatment of Excess Amounts"], which refers, in turn, to Rev. Proc. 92-93 (which is where I saw the 1099-R reference).

I believe that's correct, but I bet somebody on the boards knows for sure.

Can you confirm (or redirect me?)

Thanks!!

Employees are cash basis taxpayers who are taxed in the year when income is paid. If the contributions are refunded in 2009 then the contributions will be taxed as 2009 income.

[jpod]

It seems odd that a 1/1/09 freeze meant that no money could be deposited on or after 1/1/09. The logical inference is that it means no contributions out of pay received on or after 1/1/09. And, how is it that the custodian is in control of this type of decision-making?

[david rigby]

The fund custodian responded that, due to the freeze, they had a "hard deadline" and could not accept the contributions after 12/31/08

What does this have to do with a plan freeze? Who's in charge here?

[QDROphile]

Since it is a non-ERISA plan, the employer is not in charge.

[jpod]

QDRO:

Slight overstatement on your part, I think.

(a) Could be a public school district plan, so there would be no ERISA-avoidance issues.

(b) The employer certainly can be in charge of its own decision as to when it will stop allowing elective payroll deductions and transmission of same to vendors, without tripping the ERISA wire.

[QDROphile]

With respect to (b), the situation appears not to be a suspension of salary reduction on the part of the employer. The system looks like is shut down on the receiving end.

I agree with respect to (a), and that was an oversight. But the issue is not ERISA avoidance, the issue is, does the employer have a plan under which is has any say? Most pre-2009 non-ERISA arrangements, even with public schools, are ones in which the employer is only a conduit for salary reductions and the employer does not have a plan to freeze.

[ERISAatty]

To clarify, the employer in question is a tax-exempt hospital, and the relationship with respect to the 403(b) has been simply to serve as a 'conduit'. The hospital just forwarded employee contributions to the fund custodian.

I have not (yet) confirmed details on this particular fund (the fund that refused the post 1/1/09 contributions), but it could very well be a company that is getting out of the business of accepting new 403(b) contributions, altogether, given the final regs effective 1/1/09. I know of some companies that are taking that stance.

In any event, I'm still thinking that these monies should be returned in '09 (net of normal payroll withholdings), and that a 1099-R should be issued (with respect to the employees' 2009 tax year).

Thanks, all!

[ERISAatty]

Well, let's here it for continuing to learn.

I now believe that no 1099-R is necessary. That form is for reporting "Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.," and these amounts (never getting into a plan) are none of these.

So I am advising employee to just pay through payroll (in 2009).

[jpod]

Sorry, I don't understand.

Is the employer throwing its hands up in the air and getting out of the 403b business just because Vendor X is refusing to accept the $$? Why can't the employer make arrangements with a new Vendor to take new contributions? I don't see any legal reason why the $$ in question cannot be re-directed to another vendor, thereby preserving the pre-tax treatment which everyone thought they'd be receiving.