402(g) Excess - Correction Options After April 15

[Towanda]

Client's wife (HCE) contributed $19,500 both to her husband's 401(k) plan, and the 401(k) plan for another company she works for in 2021.  This was discovered in July 2022.

As I understand it, while EPCRS permits the participant to distribute the excess even after April 15, it may not be the best outcome for the participant.  Without going through EPCRS, any excesses remain in the 2 plans, a 1099-R is issued on the $19,500 principal for the year of excess (2021), and the funds, when distributed, become taxable again.

Without EPCRS

The spouse receives a 1099-R for 2021 reporting a taxable event in the amount of $19,500.  20 years later, at age 65, she takes a distribution, and it is once again taxable to her (plus earnings), but without the 10% early withdrawal penalty . . . correct?

Further question:  Is this undistributed excess eligible for rollover, or must it be tracked separately and processed as a taxable distribution (with applicable earnings) when a distributable event occurs?

With EPCRS

The spouse has not attained age 59 1/2.  Therefore she would be subject to the early withdrawal penalty for 2022 when she takes the distribution, and the client pays the TPA to do the painful work of preparing 1099-Rs for both 2021 and 2022.  But, the money is out of the plan, and the problem disappears.

Because the April 15 grace period has passed, does she pay an early withdrawal penalty for both 2021 and 2022?

Ugh, I know I'm overthinking this, but the more I research the worse it gets.

Thank you!

[C. B. Zeller]

Not quite. EPCRS permits a plan to correct a 401(a)(30) failure, because 401(a)(30) is a qualification requirement. If the limit was not exceeded in a single plan, or within plans in the same controlled group, then there was no qualification failure and hence no opportunity to correct under EPCRS.

Mechanically, the way it works is that the participant is limited to a deduction of $19,500 (assuming under age 50) on their 2021 tax return. Therefore, any amount contributed in excess of that is effectively an after-tax contribution. However, when it is distributed in retirement, it will be taxable as a normal distribution from a pre-tax account. So it will have been taxed twice - both going in and coming out.

[Lou S.]

To add to Zeller, neither plan did anything wrong (unless this is a controlled group) and as such there is no EPCRS correction for either plan to enter into.

Essentially what will happen at this point is she will get a 2021 tax deduction of $19,500 but will be taxed on the full $39,000 when it is eventually distributed. That is she pay taxes on $19,500 both in 2021 and the ultimate year of distribution.

It's probably exactly what Zeller said so my post might just be useless duplication.

[Towanda]

Not a useless duplication!  Thank you both!

So if this is in essence an after-tax contribution that will ultimately be taxed again, is it rollover eligible, or should it be distributed in cash when a distributable event arises?

[Lou S.]

It is eligible for rollover. Not a perfect analogy but essentially the excess acts like an after tax contribution going in and a pre-tax contribution going out.

The interesting thing that I don't think the IRS tax code considers if what happens if both of the contributions went in as ROTH to separate unrelated Plans? Mechanically what will happen is the employee essentially doubling the ROTH limit for the year since they are already taxed going in but neither Plan knows about the other so they will both not be taxed coming out. I think it's because the Excess Deferral rules were written before ROTH existed and were not updated when ROTH was added.

[Towanda]

Rabbit holes abound!  Thank you so much!

[Luke Bailey]

23 hours ago, Lou S. said:

The interesting thing that I don't think the IRS tax code considers if what happens if both of the contributions went in as ROTH to separate unrelated Plans? Mechanically what will happen is the employee essentially doubling the ROTH limit for the year since they are already taxed going in but neither Plan knows about the other so they will both not be taxed coming out. I think it's because the Excess Deferral rules were written before ROTH existed and were not updated when ROTH was added.

No. The IRS does have a rule for this, Lou S. See Treas. Reg. 1.402(g)-1(e)(8). The Roth excess deferrals, when they come out, are not qualified Roth distributions and cannot be rolled over to a Roth IRA. I have no knowledge as to whether this is uniformly administered correctly.

[Lou S.]

Thanks Luke. I have no idea how either plan would possibly every track that.

[Luke Bailey]

1 hour ago, Lou S. said:

I have no idea how either plan would possibly every track that.

That has been my thought as well, Lou S.

[KEM]

To add a question to this thread a little late -- for the excess deferral for the year of deferral, assuming the employer found out about it late and the deferrals arose under two unrelated plans (as discussed above) -- the employer still doesn't touch the W-2 for that year, correct?  The Form 1099-R is still appropriate is my understanding - just filed at the later point of actual distribution, since no corrective distributions are being immediately made for the excess deferral (so the employer leaves the W-2 alone, holds on to the excess until distributions are otherwise eligible, and then issues the Form 1099-R at that later point of distribution)?