Tax Withholding on Corrective Distributions

[davef]

If an ADP/ACP failure is corrected after March 15, there is a requirement to withhold taxes on the distributions. Since these amounts are not eligible for rollover treatment, they are subject to the 10% withholding rules. What are TPAs, etc. doing with respect to these rules? For example, are participants actually being given the election (via Form W-4P) to have withholding apply before the refund is made. Is withholding being done automatically, without an election by the participant? Is withholding being done regardless of the size of the refund? There is a $200 de minimis exception under the direct rollover withholding rules, but there does not appear to be a similar provision under the 10% withholding rules.

Any input would be helpful.

[Guest SeanT]

The procedure my firm has always taken is to allow HCEs the opportunity to make a withholding election. If the plan is approaching the 12-month deadline following the close of the plan year in which the excess occurred, and we have not heard from the HCE - the excess would be processed with 10% withholding. (This process is communicated to the plan sponsor when the testing is completed, and his/her authorization is also required.)

You mentioned that excesses not processed prior to the March 15 deadline (12/31 year-end plans) are subject to the 10% early withdrawal penalty - - Not true. Regardless of whether the excess is distributed before or after the 2 1/2 month deadline it is not subject to early distribution tax. (Treas. Reg. 1.401(k)-1(f)(4)(v))

There's a 10% excise tax to the EMPLOYER for excesses distributed after the 2 1/2 month deadline, but no penalty to the EMPLOYEE.

[davef]

When I referred to the 10% withholding rule, I meant the rule that applies to the percent that needs to be withheld on distributions that aren't subject to 20% mandatory withholding (such as an ADP refund). I wasn't referring to the early distribution penalty. Sorry if I wasn't clear. But I agree with your point that the early distribution tax does not apply.

[Guest Ben S]

I am interested in the outcome of this. Everything I see supports both of your previous comments, but we still get arguments on the applicability of the 10% withholding in Section 3405 on these corrective distributions. And the arguments come from sources that should have knowledge in this area. We want to be sure we're not missing something here.