Correction of Erroneous Deferrals (Excess Amounts / Overpayments)

[401 Chaos]

So, basic story is plan permitted deferrals from some types of bonuses but not others.  Due to admin / payroll error, all bonuses were considered eligible comp and some deferrals were made from ineligible bonuses.  The amounts were not great and the company caught after a couple of years but a few of the participants have since terminated and taken distributions.  The distributions included the erroneous deferrals tied to the ineligible bonus amounts (that would have been treated as regular wages had the plan been properly administered) plus corresponding matching contributions and earnings.  Some of the terminated participants rolled the amounts over to IRAs or other plans and some just took a taxable distribution when they left.

Employer is self-correcting and wrote letter informing former participants of the errors,  that the excess amount distributed was not eligible for rollover etc., and asked the former participants to return the full excess amount to the plan.  Interestingly, one former participant who rolled to an IRA has indicated he is wiling to return but asking about process.

I'm trying to understand how the deferral portion of the excess amount gets handled here?  The deferral portion should have been taxable wages subject to withholding generally.  Here, the plan will presumably get the full amount back  and will put the match amounts back in a suspense account but how does it get the deferral portion to the participant.  Will the IRA return and issue a 1099-R noting distributions per EPCRS (Code E)?  If the 1099-R is issued, it seems that just reflects the removal of the amounts from the IRA.  How should the employer return the erroneous deferral amounts to the former employee--report on a 1099-R, a 1099, a corrected W-2 for the year deferred? 

As a twist, how would this get handled for somebody that had received a taxable distribution and returned the amount?  Can they just get the matching contributions and earnings back and let the deferrals go then since they were already taxed?

Am I making this more complicated than it is?  The guidance I've seen just seems potentially incomplete with respect to addressing all the possible tax issues.  Thanks.

[Luke Bailey]

The deferrals should never have been withheld by the employer, put into the plan by the employer, or distributed from the plan. An amount equal to the portion of what is returned to the plan that consists of the erroneous deferrals should be paid back by the employer to the employee as taxable wages, reportable on W-2 for year when paid. Would have to check whether there is any FICA or FUTA. Once the employer has done that, it has "bought" any amount returned to the plan as the deferrals and can allocate that as a contribution or use to pay plan expenses, depending on what plan document says.  The timing of the deduction(s) gets complicated, and you've also got potential application of tax benefit rule, plus practical considerations, but bottom line the employer paid twice (once into the plan originally, once to employee as correction), and so should get a net of two deductions.

[401 Chaos]

Thanks, Luke.  That is what I was generally thinking as well but the plan's recordkeeper and advisor seem at a loss and resisting the notion of issuing any W-2.  I don't see how that isn't the case though.  As you note, the employer is returning wages to the [former] employee so seems like that should be reported.  Is anyone aware of any EPCRS guidance / examples that discuss this that I could show to back this up?  I've not found anything expressly discussing the W-2 requirement. 

Surely this is not all that uncommon of an issue?  Thanks.

[Eric Taylor]

I've looked for similar guidance in the past but unsuccessful.  Has been awhile though so maybe there is something out there now.  The more interesting (complicated) question we faced was the one noted where the former employee just took a taxable distribution and didn't roll over to another plan or IRA.  There the amounts have been treated as taxable (including the match amounts that they won't get the benefit of upon return) but the erroneous deferrals have never been reported as taxable wages by the employer.  Does the employer still report the return of those amounts on a W-2?  Should they credit the former employee with taxes presumably paid on the match portion of the prior distribution if the employee returns the full amount?

[Luke Bailey]

12 minutes ago, Eric Taylor said:

I've looked for similar guidance in the past but unsuccessful.  Has been awhile though so maybe there is something out there now.  The more interesting (complicated) question we faced was the one noted where the former employee just took a taxable distribution and didn't roll over to another plan or IRA.  There the amounts have been treated as taxable (including the match amounts that they won't get the benefit of upon return) but the erroneous deferrals have never been reported as taxable wages by the employer.  Does the employer still report the return of those amounts on a W-2?  Should they credit the former employee with taxes presumably paid on the match portion of the prior distribution if the employee returns the full amount?

Eric, luckily (sort of) FICA and FUTA is taken out of elective deferrals when they are made. So if the participant did not roll over, he or she will be fully paid on his or her tax liabilities, as will be the employer, whether the income is reported on 1099-R or W-2. I think a lot of folks would just let it go at that and not bother with a W-2 in such a situation.

If the employee returns the match, including the amount of taxes paid on the match (which I think is the minority of cases), then if it is in the same year as the distribution, you should be able to treat this as a rescission and the employer would either not report the distributed amount on a 1099-R, or would issue a revised 1099-R, so that the employee would not be taxed on the portion of the distribution attributable to the match. Of course, if the employee returns to the plan the gross amount of the distribution attributable to employer contributions, he or she will have to go out of pocket for the amount withheld at the time of distribution (e.g., 20%), but he or she gets it back when files 1040, since that amount will be a refundable credit against his or her tax liability, and so in the end is made whole. If the return of funds is in a later tax year than the distribution, you are into the wonderful world of claim of right and Section 1341. The employer's reporting (i.e., whether it issues a corrected 1099-R) will of course be of great practical importance to the employee's tax issues.