402g Excess-Can it be distributed after 4/15?

During the 2022 plan year, the company made the deductions from payroll, but they were never submitted to the recordkeeper.  They were in the process of changing payroll providers.  When the contributions were deposited (late) in 2023, 3 participants were over the 402g excess.  The plan sponsor is now requesting a distribution of these excess amounts.  

The accountant is telling the client remove the 402g excess and report/pay penalty on the form 5330.  I believe they are confusing the late contribution and needing to file a 5330 for that.   Since none of the impacted participants are over 59 1/2, can they distribute the money from the 402g excess?  I realize they will be double taxed (2022) and then in year of distribution.  If they are allowed to distribute, I believe they are subject to the 10% premature distribution penalty.  Can/Should they distribute the money?  I am thinking there is no distributable event to permit the distributions, therefore the money stays in the plan.  Thoughts?

My take? Ok to distribute under SCP, yes to double taxation, no to 5330, no to premature distribution penalty.

Going forward, they need to fix the payroll because that's where 402g excess issues are fixed (excluding issues with the participant in two plans) before they happen.

Technically, this is a 401(a)(30) violation and is corrected using EPCRS Appendix Section .04 which calls for a refund of the excess and double taxation.

It also is a late deposit since the deductions were taken in 2022 but not submitted to the recordkeeper until 2023.  The employer was late in segregating those deposits to be beyond the control of the employer and the employer had use of those funds until they were submitted in 2023.  This is a different violation which seems to be the focus of the accountants.  The correction for late deposits would call for calculation of lost earnings and potentially paying an excise tax.

The employer should check what was reported on the employees' W-2s to see if the excess deferrals were included in the reported deferrals and excluded from taxable income.  If so, then each employee should be notified that they should file an amended return for 2022 to recognize the taxation in the year of deferral.  They also should be notified that the excess will be taxed again in the year of distribution.

The employer also should check to see what deferrals were used in the 2022 ADP test (if applicable).  If an employee was an NHCE, the excess would not be included, and if an employee was an HCE, the excess would be included.

Per EPCRS Appendix Section .04, if the excess deferrals were Roth deferrals, the excess deferrals are still treated as taxable both in the year of inclusion and the year of distribution.  This seems to based on the notion in 1.402(g)- 1(e)(1)(ii) that excess deferrals are treated as employer contributions.

12 minutes ago, Paul I said:

The employer should check what was reported on the employees' W-2s to see if the excess deferrals were included in the reported deferrals and excluded from taxable income.  If so, then each employee should be notified that they should file an amended return for 2022 to recognize the taxation in the year of deferral.  They also should be notified that the excess will be taxed again in the year of distribution.

I agree that this should be checked, but it really shouldn't be possible that the p/r provider could screw this up. I get that it was a mid-year change in providers, but unless something is really whacky, I doubt their system could exclude excess deferrals from taxable income on the W-2. And even if they did, I'm pretty sure it would (should) be picked up at the time of filing the 1040, so there really shouldn't be a need to file an amended return(s)...unless there were multiple screw-ups by multiple parties, which I guess is possible.

There's a lesson in here about changing p/r providers mid-year. And there's the issue of this coming to light...now?

The situation gets even better.   The w-2s showed the correct amounts withheld.  For example, the w-2 showed $22,500 in deferrals (not c/u eligible).  Prior to 4/15, they only corrected $1000.  When they finally deposited the money in Sept 2023, they realized there was an additional $1000 in excess.  I am guessing maybe the prior recordkeeper said we only received $21,500.  Something seems a bit fishy. 

1 hour ago, justatester said:

The situation gets even better.   The w-2s showed the correct amounts withheld.  For example, the w-2 showed $22,500 in deferrals (not c/u eligible).  Prior to 4/15, they only corrected $1000.  When they finally deposited the money in Sept 2023, they realized there was an additional $1000 in excess.  I am guessing maybe the prior recordkeeper said we only received $21,500.  Something seems a bit fishy. 

I think if the W-2 was "correct" (that is, limited deferrals to the max) you have a different problem (not an excess deferral, some kind of deposit error combined with a withholding error). It might possibly be returned to the employer as a mistake of fact but that is generally related to a wrong DOB or DOH or similar error; if there are company contributions to the plan I'd prefer to leave it in the plan and move it to an employer source, and then the employer and the employee can reconcile the issue outside of the plan.

I'm confused by all of it. Are you thinking there was a total of $2000 overwithheld and deposited? $1000 "corrected" by 4/15? 

Confused is a good word for the situation.  I am being told that the w-2 reflects a $2000 excess.  They only returned $1000 excess by 4/15.  The additional $1000 is still in the participant's account. 

Historically, we take the position that there is no distributable event to allow for the 402g excess to be removed after 4/15.  It remains in the plan to be distributed at a later time.  At that time, it is taxed again.

This is where the correction procedure for a 401(a)(30) using EPCRS Appendix Section .04 which calls for a refund of the excess and double taxation can be helpful.  Again, the viewpoint for 401(a)(30) is the excess is treated like an employer contribution so it is not subject to the restriction on withdrawals that apply to salary deferrals.

You can distribute the correction now, trigger the taxation, and clean up mess.  The longer the excess remains in the plan, the greater the likelihood it will be not be treated properly in the future.

Sorry, I got the years mixed up and was thinking there was no problem with $22,500. Paul I's answer above recaps it nicely.