ADP test failed but HCE already has rolled over his account to an IRA

[Brenda Wren]

I have an HCE terminating and requesting distribution. Plan typically has a testing problem (using current year method). Should I allow him to take 100% of his account balance? How do I handle a test failure if he has already taken his money and rolled it to an IRA?

[MWeddell]

Whether the employee is entitled to receive a distribution depends on the forms of benefit payment specified in the plan document and no employer discretion is permitted. Under the all of the plan documents I've read, there are no provisions for delaying distributions to HCEs due to anticipated failure of ADP/ACP tests. Hence, although you should check your own plan document, I doubt that you legally can delay the distribution.

If the participant takes a complete distribution and rolls it over into an IRA and later you discover that part of the distribution was ineligible for rollover because part of it now constitutes correction refunds for the ADP/ACP tests, then Code Section 408(d)(5)(B) applies. Provide the taxpayer with a letter saying that it was reasonable to rely on the initial distribution statement indicating that the entire distribution was eligible for rollover, but that it turns out that due to the ADP/ACP test failure that information was erroneous and $x was ineligible for rollover. Tell the taxpayer to take this letter to his or her IRA custodian and the custodian should provide a tax free distribution of the ineligible rollover amount from the IRA. Your plan will need to revise the 1099R info so that the taxpayer is now taxed on $x.

For years, it was unclear whether the same type of rule applies if the participant rolled over the distribution into another qualified plan, but Treas. Reg. 1.401(a)(31)-1(Q&A 14), finalized in April 2000, finally addressed this. The tax consequences aren't spelled out, but if the recipient plan trustee knows that the taxpayer will get taxed on the distribution from the original plan, one hopes that it would refund the ineligible rollover from the recipient plan without taking taxes.