Correcting a plan limit failure with Roth + pre-tax ED

[roy819]

A 401(k) plan allows for Roth contributions. It also contains a provision limiting deferrals to 10% of participant compensation.

A participant contributes 12% of their pay in both ED (pre-tax) and Roth throughout the year (1/1/2025 through 12/31/2025). It is now just discovered and deemed an operational failure for not following the terms of the plan document.

The plan document does not outline how this should be corrected. The plan sponsor is self-correcting under EPCRS.

Is there any guidance on how to determine what excess to refund? (given that the participant deferred both pre-tax and Roth) Is it last in - first out? Is it prorated somehow? Or is there no guidance on this and the plan sponsor should just choose something and be consistent?

 

[Peter Gulia]

If the point you ask about isn’t in the IRS’s correction procedures, consider:

Remove the excess from the elective-deferral non-Roth and Roth subaccounts in the same proportions that the participant contributions (including the incorrect amounts) had been directed to those non-Roth and Roth subaccounts.

That way might approximate what would be the account had the incorrect amounts not been taken from the participant’s pay.

And it might lessen a participant’s opportunity to make an after-the-fact tax-treatment choice.

Yet, this might be merely one of a few ways to correct the failure.

This is not advice to anyone.

[WCC]

You have probably already thought about this, but I will ask... Is the participant catch-up eligible? Could that be the reason the payroll system allowed this individual to exceed the document limit of 10%?

[Paul I]

If I understand the issue, the plan limit is 10% of the sum of the pre-tax and Roth deferrals for the year, the excess deferrals are excess amounts that must be refunded.  The correction is to make a refund so the total of deferrals remaining in the plan are 10% of compensation.  The correction method does not specify any requirement on whether that the refunded excess amounts must reflect proportion of pre-tax and Roth deferrals that were originally made into the plan.  The plan also has no guidance.

With the lack of specific guidance, its on the Plan Administrator to decide how the plan will address the situation.  The PA needs to keep in mind that this type of operational decision establishes a precedent for future occurrences.  One consideration for the PA to keep in mind is the time and effort involved in making the refund.  Operationally, refunding from pre-tax first before refunding any Roth is far less complicated than either refunding pro-rata or refunding Roth first.  Consider that refunds of Roth get into issues like tax basis accounting, possible taxation of earnings paid from the Roth account, and year of taxation.

If these are not concerns for the PA or the PA is a masochist, then the PA could consider asking the participant to specify how much to refund from each account.

[roy819]

58 minutes ago, WCC said:

You have probably already thought about this, but I will ask... Is the participant catch-up eligible? Could that be the reason the payroll system allowed this individual to exceed the document limit of 10%?

Not catch-up eligible. Good call out though and I should have included that fact in the original post. I think it was just an error from the payroll provider. 

[Peter Gulia]

There is much to like in Paul I's sense about avoiding an ordering regarding previously-taxed amounts if a corrective distribution would not be a Roth-qualified distribution.

[CuseFan]

Bigger picture questions: Why in this day and age would a plan have a 10% deferral limit? Was this an HCE? If not, could plan be amended retroactively to allow for that extra 2% deferral?

[Peter Gulia]

But are there some participants who might perceive a retroactive amendment as unfair because they obeyed the then-stated 10% limit and might have desired to do more?