Correcting 401(k) Deferrals That Went in As Ordinary Instead of Roth

[401 Chaos]

Anybody worked to correct situation where employee elected Roth 401(k) deferrals for the year but doesn't discover that plan sponsor misread or made a mistake and treated deferrals as regular (pre-tax) deferrals until employee gets their W-2.

Seems the regular deferrals for 2010 need to be rechacterized as Roth deferrals but that's going to require putting in some more money in order to get to the full Roth deferral amount that was elected once you deduct taxes from the regular deferral amounts, etc.

Does plan sponsor have to make that up entirely on their end or can they request participant to pay the additional amounts they had already elected / agreed to contribute on an after-tax basis. I have not researched but wonder if there is an EPCRS-type solution for this?

Thanks for any thoughts or assistance you may provide.

[masteff]

Without putting pencil to paper, I'd say the employer's cheapest way out (short of saying "too bad too sad") is to recharacterize w/out correcting the withholding and offer to pay any penalty (but only up to the amount resulting directly from any underwithholding caused by this error). The requirement would be that the employee submit a copy of their tax return once it's figured and then you can have an accountant w/ tax experience in your company help you refigure the taxable income and penalty w/out the change and confirm how much of the penalty is the company's responsibility.

(If you were still w/in the same tax year and the employee had enough income to cover the extra withholding, then yes, I'd look at fixing it via the payroll system to correct the withholding but since you're in a new year, that route is now more than a little messy.)

[401 Chaos]

Thanks. In this case, we're looking at from the participant's (friend of colleague) perspective and employer is not our client so not sure we really care in this instance about what's cheapest or easiest for the plan sponsor (other than we expect that to factor into their response). Individual here is willing to pay in additional amounts that he received after-tax to fund the Roth account to the maximum amount elected but just wondered if there might be thought that the employer should have to cover some portion of this (like when they erroneously exclude an eligible employee making regular 401(k) deferrals.) Employer here initially seems to be shy about doing anything other than switching existing amounts and taking out applicable withholding but that leaves a good bit less in the account than what individual elected.

[masteff]

The only impact on payroll of regular vs Roth is income tax withholding. Payroll taxes like FICA, FUTA, etc. apply both ways. So a year-end reclassification only impacts withholding; it has no effect on payroll taxes. So... your friend's employer doesn't need to rerun a bunch of prior period payrolls to fix this. It can simply be done via plan recordkeeping and a W-2 adjustment.

If the employer won't let him write a check for the withholding (instead of taking it out of the plan), then simply ask the employer to not adjust the withholding at this point. This lets them reclassify the entire amount of deferrals from regular to Roth. And then your friend can take his available cash and mail an estimated tax payment to the IRS since we're still before the Jan 18th due date (Form 1040-ES).

[masteff]

Just thinking this thru again... looking back at your posts, you're asking the wrong question. We don't have a proper mechanism for him to put some amount into his Roth account after a correction is made BECAUSE the correction should not involve taking money out of the plan. The question you should be asking is how can they fix the withholding without taking money from the plan... and that is by them accepting a check from him for the amount needed.

[Kevin C]

Rev. Proc. 2008-50 asks for comments on your situation. That section might be helpful.

Rev. Proc. 2008-50, Section 2.02(3) Designated Roth contributions. Comments are also specifically requested on special issues relating to designated Roth contributions. For example, comments are requested on whether, if a plan failed to implement a participant's election to have a designated Roth contribution made on his or her behalf, but instead a pre-tax elective deferral was made for the participant with the participant's compensation reduced accordingly, would it be an appropriate correction for the failure for the employer to ask the participant whether correction should be made by a transfer of the contribution (with earnings) to a Roth account and inclusion of the amount so transferred in the participant's compensation in the year of the transfer (instead of either (i) a similar transfer with a corrected W-2 for the year of the failure and the participant having to complete an amended return for the year of the failure or (ii) a similar transfer and inclusion of the amount so transferred in the participant's compensation in the year of the transfer, but with the employer to make a grossup payment to the participant to make the participant whole for the resulting income tax). Comments are also requested regarding cases in which a plan fails to notify an employee of his or her right to elect designated Roth contributions, such as whether the correction for the failure described in the preceding sentence should also be applied in this case or whether some additional corrective contribution should be required to reflect the possibility that a participant's decision to make an elective deferral might be affected by the availability of designated Roth contributions. See also section .05(3) of Appendix A and Example 3 of Appendix B, section 2.02(1)(b), for an illustration of correction for exclusion of otherwise eligible employees from being able to make elective deferrals, which applies without regard to whether the plan only permits pre-tax elective deferrals or whether the plan also permits designated Roth elective deferrals.

[MARYMM]

The only impact on payroll of regular vs Roth is income tax withholding. Payroll taxes like FICA, FUTA, etc. apply both ways. So a year-end reclassification only impacts withholding; it has no effect on payroll taxes. So... your friend's employer doesn't need to rerun a bunch of prior period payrolls to fix this. It can simply be done via plan recordkeeping and a W-2 adjustment.

If the employer won't let him write a check for the withholding (instead of taking it out of the plan), then simply ask the employer to not adjust the withholding at this point. This lets them reclassify the entire amount of deferrals from regular to Roth. And then your friend can take his available cash and mail an estimated tax payment to the IRS since we're still before the Jan 18th due date (Form 1040-ES).

The employer is not allowed to accept a check for the withholding. See page 17 of Pub. 15 (2011 edition). The estimated tax payment is the only option for paying the taxes now.

[masteff]

Thanks for catching that, Mary!!!

[DMcGovern]

The plan has to treat the deferrals as Roth deferrals - that is what the Participant elected and is recorded on his form. The employer just did not treat them properly and has a payroll issue. Basically, the participant would most likely pay additional taxes due when filing their personal tax return. The W-2 supplied by the employer should show the deferrals as Roth after-tax deferrals, not pre-tax deferrals. If it does not, they need to issue a corrected W-2.