Excess Deferrals for 2007

[Janice F]

We are the CPA firm trying to complete the client's 2008 tax return. Client had an excess 401k deferral of $12,000 in 2007 (she participated in 2 different employer plans). We correctly included 12K as taxable wages on her 2007 Form 1040. We advised her to have the excess deferral distributed to her before 4/15/2008 to avoid 'double taxation'. Client failed to do so. Client then took a total distribution from her 401k, after 4/15/2008 as a direct rollover to her IRA. I understand that if she would have taken a lump sum distribution of her 401k balance during 2008 but after 4/15/08, she would have not have 'basis' and would have been taxed again on the $12,000. But what happens now that the money is in an IRA account? How can this be fixed and what are the tax implications? Also, what about the related match on the excess.

[Guest Sieve]

I don't see the problem. You always have a zero basis in funds in a qualified plan or IRA if the contributions were pre-tax. By not taking the distribution of the excess deferral timely, then the excess deferral ($12,000) was treated as if it was pre-tax (i.e., like any other deferrals) even though it was really after-tax deferals). And when the funds are eventually distributed from the IRA, they will be taxable. Double taxation, just what the Code requires. What am I missing?

I assume the match follows the excess deferral--i.e., the deferral wasn't paid back, so the match will not be forefited.

[Janice F]

I don't see the problem. You always have a zero basis in funds in a qualified plan or IRA if the contributions were pre-tax. By not taking the distribution of the excess deferral timely, then the excess deferral ($12,000) was treated as if it was pre-tax (i.e., like any other deferrals) even though it was really after-tax deferals). And when the funds are eventually distributed from the IRA, they will be taxable. Double taxation, just what the Code requires. What am I missing?

I assume the match follows the excess deferral--i.e., the deferral wasn't paid back, so the match will not be forefited.

I believe that the excess deferral in the 401k plan was not eligible to rollover to the IRA, so I'm thinking that the $12,000 should be corrected by removing it from the IRA by April 15th to avoid the 6% excess IRA contribution penalty. But then is it taxed in 2009 when distributed from the IRA? Or taxed in 2008 when 'distributed' from the 401k since it never should have gone into the IRA in the first place?

p.s. - although I am a CPA, I don't prepare 1040 returns. The 1040 person at my firm is asking me for advice since I work with clients on their 401k and DB plan audits and 5500s.