"Sham" Transfer When Not Eligible for a Distribution

[EPCRSGuru]

This is an interesting situation. A 403(b) plan sponsor has three vendors and no central record-keeping. Transfers among vendors are processed by accessing the vendors' web sites.

One participant who believed he had an immediate right to "his" money (salary deferrals only) applied for a direct transfer, but directed the check to his IRA instead of to the plan. He then transferred the funds out of the IRA, much of it after he was notified that he was not entitled to a distribution and asked to restore the funds. He is adamant that he is within his rights and that his attorney has told him that he is in the clear. (He is actively employed, under age 59 1/2 and did not request a hardship withdrawal.)

Sponsor has consulted ERISA attorney. Both the plan sponsor and the receiving vendor have explained the distribution rules and requested in writing that the funds be restored to the plan. They do not expect he will comply.

So, this is what I think happens.

1. Plan sponsor takes a good look at their processes for handling transfers!

2. Paying vendor reports this as a premature distribution since the instructions on the transfer request included the IRA account number and the plan never received the funds. 10% excise tax and income tax results.

3. Receiving vendor reports this as a premature distribution from the IRA, also resulting in a 10% excise tax and income taxation.

20% total excise tax AND income tax on the same money twice? Technically, funds were probably not eligible for rollover--does that make yet another penalty?

I'd enjoy talking to the lawyer who [allegedly] told participant this was OK.

[Bird]

While it's tempting to want the money to be taxed and subject to the 10% penalty twice, I don't think that is appropriate. You said it went into an IRA, and then came out of the IRA, so the first transaction, IMO, should be reported as it actually happened, a direct rollover, not subject to tax or penalty. The fact that it was fraudulent or otherwise inappropriate is another matter.

[EPCRSGuru]

That is the interesting part of the question. (Fortunately it is not my decision, as it is with the sponsor's legal people.) If the participant was not eligible for a distribution, does that mean it is not an eligible rollover distribution and therefor not eligible for rollover?

[masteff]

If the participant was not eligible for a distribution, does that mean it is not an eligible rollover distribution and therefor not eligible for rollover?

You might see if the logic in the following thread seems to apply to your question:

http://benefitslink.com/boards/index.php/topic/44985-impermissible-distribution/

From EPCRS:

(4) Overpayment. The term “Overpayment” means a 403(b) Failure due to a payment being made to a participant or beneficiary that exceeds the amount payable to the participant or beneficiary under the terms of the plan or that exceeds a limitation provided in the Code or regulations. Overpayments include both payments either made from the participant’s or beneficiary’s 403(b) custodial account or annuity contract under the plan or not permitted to be paid under the Code, the regulations, or the terms of the plan. However, an Overpayment does not include a payment that is made pursuant to a correction method provided under this revenue procedure for a different 403(b) Failure. Overpayments must be corrected in accordance with section 6.06(4).

And:

(e) Notification of employee. Except as provided in section 6.02(5)© with respect to the recovery of small overpayments, the employer must notify the employee that the Overpayment was not eligible for favorable tax treatment accorded to distributions from an eligible retirement plan under § 402©(8)(B) (and, specifically, was not eligible for tax-free rollover).