withdrawal of excess contribution

[Guest benefit questions]

Hello. I have a question I'm hoping for some advice... After I was laid off last year, I withdrew my 401(k) and had it deposited into an IRA account. That all went smoothly. However, this fall, I was contacted by the former 401(k) custodian, indicating that they discovered an incorrect divided had been included in that account and therefore an overpayment had been made. They requested the excess payment be returned in order to avoid tax consequences for the incorrect distribution.

I delivered that correspondence to the IRA custodian. The IRA custodian sent me TWO checks--payable to me--one for the exact amount of the overpayment, and a second check for the earnings attributable to that overpayment.

I questioned why the checks were made payable to me instead of the new custodian, and spoke with the 401k custodian--who advised that some brokerages do it that way and it was not a problem--and she instructed me to deposit the checks and write them a check out of my own personal account--and the IRA custodian, who confirmed that she had followed company procedure and had coded this all as a "withdrawal of excess contribution." Anyway, so far so good.

Upon receipt of my check (as instructed), the 401k custodian advised that she had misunderstood my question, and that they were unable to accept any of the earnings from that initial incorrect dividend. She is having a check cut, payable to me, refunding the amount of the check that represented the earnings from the incorrect dividend. She stated that it was improper for the 401k custodian to have withdrawn those funds and this will result in a tax consequence to me.

401k custodian insists that she did nothing wrong or improper and tells me I should just deposit the "earnings" in my bank account and pay the associated taxes and any penalties.

I'm caught in the middle. Who is right? In my mind, the ITA custodian/fiduciary withdrew my money improperly, and now I have a tax hit, which I did not want or anticipate. But, perhaps if the earnings were based on money that was not supposed to be in the account in the first place, that is just the way it works and there is nothing to be done.

Is there a way to correct/undo all of this, or is this just how it works. Thanks for your thoughts and advice.

[masteff]

They're both right. See "Excess Contributions Withdrawn by Due Date of Return" on page 50 of IRS Pub 590. http://www.irs.gov/pub/irs-pdf/p590.pdf

You have to give the dividend back to the 401(k). But the earnings on the dividend can't stay in the IRA because they should have been there in the first place.

It's basically a windfall for you. You get to keep the earnings on the money they shouldn't have given you, BUT you have to pay a small amount of tax and penalty on that windfall. If you do the math, you'll find that you have more cash afterwards than before... you come out ahead.

[MWeddell]

Due to the nuisance factor though, you probably come out behind.

[Guest benefit questions]

thanks for your help!