Hardship distribution didn't include after tax dollars

[TheRestatement3dOfTed]

401(k) participant whose account included after-tax and pre-tax dollars received an otherwise-proper hardship distribution (i.e., authorized by plan, procedures followed, right amount was paid, etc.), but which was paid entirely out of pre-tax deferrals (i.e., the distribution was paid without regard to the ordering rule requiring it to have been paid first out of after-tax dollars). To pluck some numbers out of thin air, let's say that a $10,000 hardship distribution was paid entirely out of pre-tax dollars, rather than $1,000 after-tax (representing the full after-tax account balance) and $9,000 pre-tax. As a result, the administrator treated the entire $10,000 distribution as taxable and subject to the 10% early withdrawal penalty. But if the first $1,000 had properly come out of the after-tax account, the amount of P's basis in the after-tax account shouldn't have been reduced. So the plan isn't out any money, but the tax hit to the participant was a bit larger than it should have been.

To me, it seems reasonable under the general correction principles to fix this by cutting P a check for the amount of the improper tax hit (plus interest), and moving the remaining after-tax dollars into P's pre-tax account. But EPCRS doesn't seem to directly address this scenario.

Anyone encountered this before? Thoughts?

E: I suppose one might argue that this is, really, a failure to have initially required P to withdraw the after-tax amounts before receiving the hardship, which could be corrected by requiring repayment of the portion that shouldn't have been distributed in the first place. But from the plan's perspective, the right amount (in absolute terms, anyway) was paid out. Any repayment would presumably be made with after-tax money anyway, so requiring that additional steps seems like an overly complex means of reaching the same result you'd get by recharacterizing the remaining after-tax dollars already in the plan as pre-tax...

[ESOP Guy]

Has the 1099-R been issued?

[TheRestatement3dOfTed]

Has the 1099-R been issued?

Yes, this occurred a number of years ago, but the r/k has just now brought it to our attention.

[ESOP Guy]

I don't understand why you would pay out more money. As you say the correct amount has been paid out.

Aren't there really two problems here:

1) The 1099-R was wrong in terms of how much it said was taxable. So isn't the solution to that to file a corrected 1099-R? The person would need to file an amended 1040 to get back the excess taxes paid. (If the 1099-R was issued to long ago that they can't amend I am not sure I wouldn't let a sleeping dog lie as they say)

2) The amount of basis on the recordkeeping system needs to be changed to reflect the amount of the correct after-tax basis that should have been paid. I guess if the after-tax money is in a separate daily account you might need to do a transfer to get things in the right place. I would have to think about that more.

Once again I can't for the life of me see why you would send more money from the plan. That seems to make the mistake worse as you now have paid more money that was needed to pay the distributions. That really seems like you would be going in the wrong direction.