Roth excess deferrals

[Luke Bailey]

Suppose employee X works 1/1 through 6/30 for employer A and defers the 402(g) limit in employer A's 401(k) plan, then goes to work for employer B and defers the 402(g) limit in employer B's 401(k) from 7/1 through 12/31 of same year. Assume employee X does not take steps to have any portion of the deferrals for the year from either plan distributed to him/her by the April 15 of the following year. If both deferral episodes were pre-tax, then the IRS aggregates the amounts from the W-2 data it gets from employers A and B with respect to employee X , includes the excess in employee X's gross income, and adjusts employee X's 1040. Because the amounts were allocated to employee X's pre-tax account in both employer A's and B's 401(k) plans, when they are later distributed (presumably, with earnings), it's reported as taxable on employee X's 1099-R's, so you have the archetypal double tax that you can only avoid by utilizing the process to have the excess deferrals distributed (notifying the plan(s) by April 15 of following year), which in this example employee X did not do.

But what if employee X had elected Roth elective deferrals for the amounts under both plans? The amounts are already reported in employee X's W-2's as gross income, so there should be no adjustment to his/her 1040. To the extent there is asymmetry in the treatment of pre-tax vs. Roth excess deferrals, seems like what the IRS would need to do is notify the employer that the excess Roth deferrals had been made and that those should be moved by the employer, as plan administrator, with earnings, out of the employee's Roth account and into his/her pre-tax account. But boy, that would be complicated and I have not seen anything explaining the requirement to do this. There is an example on page 19 of the current W-2 instructions that involves an excess Roth deferral under a plan of a single employer, but it doesn't touch the administrative issue that exists where the Roth elective deferrals occurred under plans of different employers.

IRC sec. 402A(d)(3) pretty clearly says that employee X is going to be taxable on the amounts attributable to the excess deferrals,  but how are the administrators of employer A's and B's plans going to know to report as taxable? Is employee X simply on his/her honor? (Both to do the right thing and to study tax law in the evenings so he/she will even understand this?)

Maybe there is a clear answer to this and I've just been out of the loop on the issue, but I am puzzled about it.

[ETA Consulting LLC]

There appears to be reliance on an 'honor' system.  In your hypothetical, it would resolve itself if the IRS taxes the entire pre-tax deferral for the year on the 1040; and taxes it again when it is finally distributed.  Let's take the hypothetical a step further.  Let's assume the same individual maxes out on Roth Deferrals in plans of two separate employers.  Now, everything has already been taxed.  As a rule, amounts attributed to the excess Roth will not receive the "Roth" treatment of having the earnings distributed income tax free.  Who's going to account for that?  The IRS?  

So, to the point I think you're making, there is a loop hole there.  A 50 year old who works for two separate employers can defer $24,500 in Roth in each plan.  While this is a violation of tax law, the onus appears to be on the IRS (who will rely on the participant) to assess the earnings on those contributions that aren't eligible for Roth treatment.  

Is that what you're getting at?

 

[Tom Poje]

this came up before, about a month ago.

the preamble to the regs (at least the propsed regs way back when had the following)

 

“Designated Roth Contributions as Excess Deferrals

Even though designated Roth contributions are not excluded from income when contributed, they are treated as elective deferrals for purposes of section 402(g). Thus, to the extent total elective deferrals for the year exceed the section 402(g) limit for the year, the excess amount can be distributed by April 15^th of the year following the year of the excess without adverse tax consequences. However, if such excess deferrals are not distributed by April 15^th of the year following the year of the excess, these proposed regulations would provide that any distribution attributable to an excess deferral that is a designated Roth contribution is includible in gross income (with no exclusion from income for amounts attributable to basis under section 72) and is not eligible for rollover. These regulations would provide that if there are any excess deferrals that are designated Roth contributions that are not corrected prior to April 15^th of the year following the excess, the first amounts distributed from the designated Roth account are treated as distributions of excess deferrals and earnings until the full amount of the those excess deferrals (and attributable earnings) are distributed. “

.....

so to prevent you from going insane, it would be wise to segregate such amounts in a separate account so you can keep track of earnings as well. the problem of course, if it involves 2 unrelated employers. neither plan might know about the issue. in addition, neither plan would be in violation for accepting excess deferrals at the plan level, so neither plan is subject to disqualification, so ultimately it boils down to the participant to tell one of the plans to do something. and we know all participants

1. know the regulations sufficiently to know what to do

or

2. are honest enough not to intentionally do something like this and inform one of the plans of the problem when they discover the issue.

[Bird]

I think there is more to it than the honor system.  The IRS will know about the overcontribution and I think it is in fact something their computers will flag on the front end.  How they would enforce the back end - taxing the distribution of supposed Roth money - I don't know.  It is very hard to imagine the "regular" (1040) IRS folks somehow telling a participant that they have to tell a plan sponsor to segregate that money for future distribution taxation purposes.

The pre-tax scenario is very simple - they will flag it (if not reported properly) and just tax you on the excess in the year contributed, and the plans don't have to do anything other than report the distribution when made.

[WCC]

here's a prior discussion on this topic.

[Luke Bailey]

Thanks for all the responses, all of which seem to be in basic agreement. I think what it comes down to is that the law is clear that the excess Roth deferrals, if not distributed by April 15 of the following year, are, under the law, considered pre-tax deferrals and the entire amount attributable to them (original deferral and earnings) is, under Code sec. 402A(d)(3),  includable in gross income when distributed from the plan and cannot rolled over. But where more than one employer's plan is involved, the onus to make this happen is on the participant. There is no way the employer will know or, without a lot of instruction from its TPA, understand, this complex accounting issue. (The occurrence is probably rare, but in an economy the size of the U.S., it probably happens 100's if not thousands of times each year.) In that regard, I don't think I've seen any preapproved plan language addressing this, or any LRM language, and I don't see anything in the W-2 or 1099-R instructions that address this, reinforcing the conclusion that enforcement, if any, on this issue is going to be "self-enforcement" by the participant. That is fine, and is the basic principle of the federal income tax generally, but the retirement world is accustomed to a complex and comprehensive reporting structure and this seems to be a "loophole," as ETA Consulting LLC puts it, in that reporting structure, though not the law itself.