ADP Refund--HCE has both Roth and Pre-Tax deferrals

Plan is failing ADP test.  One HCE getting a refund had both Roth and Pre-tax deferrals during the year.

What is the protocol for doing the refund?  From which source(s) do you start using amounts?

Is it a plan document issue?  Administrative procedure?  Does the participant have to make the final call?  (Is that even feasible if we are coming up on processing deadlines?)

As usual, your thoughts are appreciated.

At least in our plans, it is operationally determined by the Plan Administrator. However, I do believe that one or more recordkeeping platforms may require that it all come first from one source or the other. Don't know why I say that, except that I seem to recall it on a plan, but that was years ago, when Roth was still not used all that much. Might not be that way now.

This is from our basic plan document: If a Participant has both a Pre-Tax Deferral Account and a Roth Deferral Account, the Participant may
designate the extent to which the corrective distribution of Salary Deferrals is taken from the Pre-Tax
Deferral Account or from the Roth Deferral Account

If the plan document doesn't say, they can establish a procedure.

Ordinarily you probably wouldn't want to give choice about which source to take it from (since getting the election out and returned, earnings calculated, and refund processed all by 3/15 may result in a time crunch issue). I know it's one person here, but who knows how many will get refunds next year. 

To minimize current year tax impact, you may want to consider issuing the refund from designated Roth first, then pre-tax. 

34 minutes ago, bito'money said:

To minimize current year tax impact, you may want to consider issuing the refund from designated Roth first, then pre-tax. 

But issuing from Roth first then leaves in place funds for which earnings will not be distributed tax free.

Would you rather have a tax bill of $4,000 now and have the earnings on that $4,000 grow tax free?  Of have a zero tax bill today, but have the earnings over the years be taxable later?

And I found it in the BPD.  (Not sure how I missed it the first time...)

(ii) shall be made, as operationally determined by the Administrator, from the Participant's Pre-Tax Elective Deferral
Account or the Participant's Roth Elective Deferral Account, to the extent both Pre-Tax Elective Deferrals and Roth Elective
Deferrals were made for the Plan Year;
 

On 3/3/2022 at 3:11 PM, BG5150 said:

But issuing from Roth first then leaves in place funds for which earnings will not be distributed tax free.

Would you rather have a tax bill of $4,000 now and have the earnings on that $4,000 grow tax free?  Of have a zero tax bill today, but have the earnings over the years be taxable later?

There's no right or wrong answer, and luckily you can punt on this question to the plan administrator. 

As far as advising the plan administrator which one is better, if keeping the Roth in the plan is so much better for them, why would they have put some in as pre-tax as well?

Maybe they will likely be in a lower tax bracket in retirement (as is often the case) or the additional income this year could cut into their ability to make Roth IRA contributions this year, or kick them into a higher tax bracket this year. Maybe they live in a high tax state and will be moving to a low tax state when they retire. These are things in favor of distributing Roth first. (If they are already in the highest tax bracket and live in a low tax state, and already make too much for Roth IRA contributions, then maybe distribute pre-tax first, or use a pro-rata percentage of each type during the plan year).

Only the participant knows their current tax situation, and even the participant will probably not know which one would be better for them in the final analysis. You or I (and probably the plan administrator) can only, at best, make an educated guess which one would be truly better for them.   

In my experience as a recordkeeper, FWIW, HCEs tend to complain more about current tax surprises than about tax hits that occur gradually 20 years later.   

To the best of my knowledge the issue is not covered in the 401(k) regs. The closest I have come to finding "guidance" on the issue is in the IRS's List of Required Modifications (LRMs), from which the below for Excess Contributions. Virtually identical language in LRMs regarding excess deferrals:

"Statement of Requirement: Excess Contributions for a Plan Year, plus any income and minus any loss allocable thereto, must be distributed no later than 12 months after such Plan Year. If both Pre-tax Elective Deferrals and Roth Elective Deferrals were made for the year, the Plan may provide that distribution of Excess Contributions will consist of a participant's Pre-tax Elective Deferrals, Roth Elective Deferrals or a combination of both, to the extent such type of Elective Deferrals was made for the year."

The discussion seems to have concluded that a corrective distribution may be allocated between the distributee’s non-Roth and Roth subaccounts (if the plan’s governing document authorizes this, or at least does not preclude this).

Imagine a plan’s employer/administrator offered the distributees a choice for how to allocate one’s corrective distribution. But to meet BG5150’s concern about allowing some processing time before a due date, the administrator set yesterday March 7 as a cutoff for such a direction.

Today, the employer/administrator asks for your suggestion on the best default allocation for the distributees who didn’t specify a choice. What do you suggest?

Imagine further the employer/administrator says: “I don’t want to hear your we-don’t-give-tax-or-legal-advice speech. You told me the plan’s document allows any way we want to do it, so none of them is legally wrong. Just tell me what you think is best.”

What allocation do you suggest? And why?

"My suggestion - which is not to be construed as tax or legal advice - would be to do it first from Roth, as "most" people prefer to keep the current tax deduction. But if you don't like my recommendation, feel free to do it however you want. It's ultimately your choice anyway."

Another suggestion—likewise not advice—would be to distribute the refund from both the pre-tax and Roth sources in the same proportion as the employee's contributions for the year. That should avoid any appearance of preference towards one or the other.

4 hours ago, Peter Gulia said:

What allocation do you suggest? And why?

I suggest (a) saying in your plan document that you will have a policy, that may change from time to time, (b) having a written policy that says you give folks a choice, with a deadline, and (c) if they don't meet deadline, proportional to the breakdown between the two types of contributions in the account. The problem is that you can't really predict what someone would want. The Roth or more valuable, so you might want to distribute the pre-tax first. But as Belegarath notes, the participant might have been counting on the tax deduction, otherwise they would have done all Roth. Depends on the individual. And anyway, most plans that allow Roth Contributions will allow in-plan rollovers, so if the don't like that Roth were distributed, they can convert some of the pre-tax that's left to Roth, just in the later year.