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402(g) Excess (all Roth) not taken--loophole?


BG5150

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Participant defers $30,000 all Roth across two plans in 2023.  Age 35.  ($15k each plan, say)

It's too late to take out the excess.

So does that mean the earnings on the excess will stay in there and get earnings on top of that and come out tax free in 40-50 years?

 

QKA, QPA, CPC, ERPA

Two wrongs don't make a right, but three rights make a left.

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Sounds like a loophole. Though I would  think the excess contribution doesn't meet the definition of eligible ROTH contribution though which plan recharaterizes it somehow is anybody's guess. Maybe there is some guidance on this question but if there is, I don't where it would be.

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See Reg. 1.402(g)-1(e)(8)(iv):

"(iv) Distributions of excess deferrals from a designated Roth account. The rules of paragraph (e)(8)(iii) of this section generally apply to distributions of excess deferrals that are designated Roth contributions and the attributable income. Thus, if a designated Roth account described in section 402A includes any excess deferrals, any distribution of amounts attributable to those excess deferrals are includible in gross income (without adjustment for any return of investment in the contract under section 72(e)(8)). In addition, such distributions cannot be qualified distributions described in section 402A(d)(2) and are not eligible rollover distributions within the meaning of section 402(c)(4). For this purpose, if a designated Roth account includes any excess deferrals, any distributions from the account are treated as attributable to those excess deferrals until the total amount distributed from the designated Roth account equals the total of such deferrals and attributable income."

Short version as I understand it: Excess Roth deferrals and related income are taxable and cannot be rolled over.

Shorter version: less like a loophole, more like a snare.

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But to which plan is there an excess and how dose the Plan know there is an excess if the two plans are unrelated?

It seems like a problem for the Participant rather than the Plan but not one that has an easily tracked component for the IRS to catch or the Plan to properly code future 1099-Rs. Snare indeed.

Just an observation, not a suggestion to try tax fraud.

 

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But if it's after 4/15, it's not a distribution of an excess anymore, right?  It's just part of a 'regular' distribution.

QKA, QPA, CPC, ERPA

Two wrongs don't make a right, but three rights make a left.

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4 hours ago, BG5150 said:

But if it's after 4/15, it's not a distribution of an excess anymore, right?  It's just part of a 'regular' distribution.

But that's my point. if it was deposited to the ROTH source initially how will the Plan ever know it's not supposed to be in the ROTH sources and is not eligible as qualified ROTH distribution if there is no excess in their Plan? Plan A only had $15K and Plan B only had $15K. To each of them, it looks good. So which Plan has to recharcterize the ROTH excess over the 402(g) limit when neither exceeded it? If it was Pre-tax, you wouldn't need to worry because it would be taxed again when it is ultimately distributed and no special record keeping or tracking needs to be done.

But if it's in the ROTH source, when it comes out if the participant is 59.5 and 5 years, I can guarantee you that 99.9% of plans will code that as a qualified ROTH withdrawal on the 1099-R when it comes out of the Plan unless it gets moved to a different source in the Plan. And according to the guidance above, that's not correct.

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It is fair to recognize that for excess deferrals that are not a 401(a)(30) violation (i.e. the excess is not known to the plan), the participant has the responsibility to report the excess and to choose how much of the excess is in each of the plans.  It the participant does not provide this information, neither plan will know about the excess and each plan will not be able to account for the amount of the excess.  Each plan doesn't know what the plan doesn't know.

If the participant does inform a plan that it holds an excess deferral, then that plan's recordkeeper should ask for information about the amount of the excess and the type of deferral (pre-tax or Roth) that is in that plan.  Then recordkeeper should properly account for the excess going forward.

Note that the reg says "For this purpose, if a designated Roth account includes any excess deferrals, any distributions from the account are treated as attributable to those excess deferrals until the total amount distributed from the designated Roth account equals the total of such deferrals and attributable income."  If there is no separate accounting, then the first dollars out are a refund of the excess plus earnings and are not eligible for rollover.  (This is similar to what is done for RMDs.)

As evidence that @Lou S.'s odds on how this is reported are fairly accurate, I observe that I have never seen a conversion data request that asks for the amount of excess deferrals that are in a participant's account.

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Wow, this is really something. Let’s say a clueless (or pretending to be clueless) MD participates in hospital 401k plans and also has a solo 401 from his side-gig. On January 1 he defers full $30,000 as Roth in each plan.  He invests both deferrals into the riskiest investment option (or hedging one investment with another one). In plan #1 the investment is worth 3,000 on December 31. In another plan it is worth $300,000.  He chooses to treat as excess the first one.   Unless I am missing something big, this is a pretty good gambling/hedging/arbitraging option.  Please demolish my dirty thoughts.

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This general issue has come up before on BenefitsLink and the take-away has been that while the regulation quoted by Paul I plugs the potential loophole under the statute, there it probably is not being enforced. I guess the IRS could enforce it if it wanted to. Right now, if a participant goes over the 402(g) limit with pre-tax the IRS adds up the amounts on the participant's W-2's and sends the taxpayer a notice that it is including the excess in income. Given that Box 12 will show whether some or all of the deferrals were Roth, the IRS could do a little more math and advise the participant that a portion of the amounts they had contributed as Roth would be included in income, earnings also, on the way out of the plan. But it would be complicated, although not impossible to enforce after that point. I don't think they are doing this, though.

Luke Bailey

Senior Counsel

Clark Hill PLC

214-651-4572 (O) | LBailey@clarkhill.com

2600 Dallas Parkway Suite 600

Frisco, TX 75034

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Here’s my question:

Imagine someone who advises the individual, and does not advise either of the employment-based retirement plans. If you think it matters, imagine this adviser is an attorney-at-law, a certified public accountant, an enrolled actuary, an IRS-enrolled agent, an IRS-enrolled retirement plan agent, or one who wears none of those stripes—your choice of illustration.

In advising the individual, is it professionally and ethically permissible to provide advice that explains the tax law, including 26 C.F.R. § 1.402(g)-1(e)(8)(iv), AND explains that the IRS lacks resources to detect that a later distribution includes amounts the individual ought to treat as a return of excess deferrals?

If you think the advice about nondetection is inappropriate, why?

I’m developing a point in my summer-semester course, Professional Conduct in Tax Practice. I’ll keep these observations anonymous, unless you prefer attribution.

Peter Gulia PC

Fiduciary Guidance Counsel

Philadelphia, Pennsylvania

215-732-1552

Peter@FiduciaryGuidanceCounsel.com

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I am (a) not very well versed on this issue and (b) of the same view as C.B. Zeller. But also, is there a difference between saying, "I have no idea how they can check for that" and "Here's what you can do to flout the regulation and not pay tax." Doesn't the latter border on some sort of fraud, at least civil, or conspiracy to evade tax? It is definitely evasion that is in question, not avoidance, assuming the reg is a valid interpretation of the law.

Luke Bailey

Senior Counsel

Clark Hill PLC

214-651-4572 (O) | LBailey@clarkhill.com

2600 Dallas Parkway Suite 600

Frisco, TX 75034

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On 5/8/2024 at 2:44 PM, Paul I said:

Note that the reg says "For this purpose, if a designated Roth account includes any excess deferrals, any distributions from the account are treated as attributable to those excess deferrals until the total amount distributed from the designated Roth account equals the total of such deferrals and attributable income."  If there is no separate accounting, then the first dollars out are a refund of the excess plus earnings and are not eligible for rollover.  (This is similar to what is done for RMDs.)

As evidence that @Lou S.'s odds on how this is reported are fairly accurate, I observe that I have never seen a conversion data request that asks for the amount of excess deferrals that are in a participant's account.

If TPA/RK does not know that there is excess, for sure it will be coded wrong. If the TPA/RK is notified(or knows) that there was an excess, and that excess cannot be be distributed until a future event, the excess and allocable earnings could be moved to separate excess source.  I have never seen that in conversion data either though...

 

 

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