Must an employer’s payroll impose a during-the-year cutoff on elective deferrals?

[Peter Gulia]

In 2025, a particular participant’s limit on elective deferrals might involve four (or more) variations, turning with the participant’s age (0-49, 50-59, 60-63, 64-).

Some employers might try, in payroll, to impose a during-the-year cutoff on § 401(k), § 403(b), or § 457(b) elective deferrals. But some employers might lack software or other ways to impose such a cutoff reliably. For some, imposing an unnuanced cutoff could deprive a 60-63 participant or even participants older than 49 of what might be a legitimate elective deferral.

How important is it to apply a cutoff during a year?

Or is it good enough that each January an employer checks the recently closed year’s sum of amounts paid over for elective deferrals to find each individual with an excess and instruct a corrective distribution?

In which situations would an excess deferral not be corrected by a corrective distribution or by W-2 reporting?

[CuseFan]

Peter, as one who does not get involved in that level of administration, I'll give you my opinion from a top-level viewpoint FWIW.

"Must" the payroll function cut off deferrals when limits are reached? No. "Should" the payroll function have the ability to recognize the highest applicable limit available to a participant and only stop deferrals once that limit is reached? Yes, in a perfect world, and certainly yes for any payroll service company that claims to be full service. For those companies that use third party software to run their own payroll in-house, such software may lack the ability or the users lack the programming skills to properly account for all the new complexities associated with recent legislation. In those instances I think they should make every effort to properly administer limits and try to at least account for most situations.

Yes, it is easy enough to identify and correct excess deferrals after year-end through corrective distributions (I am not a proponent of playing with W2s after the fact). Besides the added administrative work, the other ramification could be under withholding on income taxes for an affected individual who gets a material taxable refund. The employer would need to make sure recipients were able to make timely tax withholding elections on their refunds to avoid be under withheld.

If I'm the employee, I might consider this a big hassle and ask why should I have this inconvenience because my employer or its payroll provider can't properly administer legal limits? Furthermore, if I'm expecting my deferrals to be stopped at a certain point and they aren't, I'm not getting a part of my pay that I was expecting. Yes, I could then elect to cease deferrals, but then I have to elect to restart come 1/1, putting the administrative burden on me the employee.

Anyway, that is my humble opinion.

[Paul I]

My response to the question How important is it to apply a cutoff during a year? is it is very important, but not mandatory. Anytime excess deferrals are taken by payroll, it is a violation of 401(a)(30) and an operational failure.  If the excess deferrals are not removed by April 15th of the following year, the plan could be subject to disqualification (unlikely to happen) but the correction must go through EPCRS (which is not cheap).  Note that a 401(a)(30) failure is a payroll failure that differs from a 402(g) violation which is a participant failure (e.g., where the participant had deferrals made while working for unrelated companies).

From what I have seen, 401(a)(30) failures are more likely to occur when there was a change in payroll systems/providers.  Another relatively common 401(a)(30) failure occurs when there are other related companies such as within a controlled group where payroll was not run on a common payroll system/provider and a participant had deferrals taken from multiple payrolls that did not share YTD information.

Technically, all excess deferrals should be corrected through refunds which would address the distribution of earnings on the excess deferrals.  If the refunds are not made by April 15th, the excess deferrals are corrected through EPCRS (SCP, VCP or Audit Cap) and are taxable in the year of deferral (except for Roth deferrals) and in the year of distribution (including the amount of any Roth deferrals).  According to the IRS web site (https://www.irs.gov/retirement-plans/401k-plan-fix-it-guide-elective-deferrals-werent-limited-to-the-amounts-under-irc-section-402g-for-the-calendar-year-and-excesses-werent-distributed) the refund could be subject to the 10% early distribution penalty, 20% withholding and spousal consent rules.