Incorrect Deferral Election Deposits (Roth vs Pretax)

This issue started in 2022 (before my time at my company and is still lingering through 2023) and I just wanted to get some opinions on how to correct:

Employer deducted several participants Roth as pretax (2022 W-2s reported as pretax) but deposited as Roth with recordkeeper. 

We discovered while working on 2022. On annual admin report, we reported as all Roth (tying to RK, but differing from W-2s).  

We gave them these options to correct 2022: 

·  Employees can choose to maintain their Roth election. The employer has two options to report the mistake:

o Issue corrected W-2s and the amount will be considered taxable to the employees for year 2022.

o Include the amount that was incorrectly designated as a Pre-Tax deferral in each employee’s compensation in year 2023. Given it was an employer mistake, you may elect as the employer to compensate these employees for the additional amount owed in income tax (treated as current year income). This would be a complicated process, requiring an estimate of how much each employee would owe in taxes. You would need to reach out to your accountant for this.

They have not amended the W-2s and do not intend to at this point, nor have they made up the taxable amount.  

This lingered into 2023, so they first few payrolls were also incorrect.  The employer does not intend to amend the 2023 W-2s either and had indicated to use what was reported on the W-2s and make adjustments at the RK to match the W-2s (i.e. move money between sources).  When we sent a correction to the RK to make these adjustments, they indicated since 2022 was not done this way, they didn't think 2023 should be either.  

We aren't sure how to handle - the IRS would surely be upset they are missing out on the taxes and the DOL would surely be upset the deferral elections were not processed correctly.   

Any insights on how you would handle?

The IRS addresses how to handle the situation here:

https://www.irs.gov/retirement-plans/fixing-common-mistakes-correcting-a-roth-contribution-failure

Note that the plan may be able self-correct if the situation can be considered insignificant.  Since it was the company's mistake, they should make keep the participants whole.  This may include covering any penalties and interest that may be assessed.

Willfully Ignoring the problem is a bad idea.

In addition to the standard options provided by the IRS website, what about having the plan issue 1099-R showing the amounts (base amounts) as taxable?  as an in-plan Roth conversion

Then the recordkeeper also recodes the earnings as Roth as a corrective actions. 

Advantages:

The participant's tax situation is pretty much what it would have been

The plan is the position it would have been

no need to redo any W-2s. 

Disadvantages

Tax returns might need to be redone depending on what year the 1099-Rs are for

it isn't quite the same method the IRS provides

From the point of view of recordkeeping, treating the amounts posted in the system as pre-tax and accounting for the correction as if an in-plan Roth rollover occurred is creative and gets the plan accounting close to what should have happened, but consider some of the other potential implications of of this approach.

The impact on the personal taxes for each individual could vary significantly.  The amount of Roth deferral reported as taxable on a W-2 could increase an individual's marginal tax rate for the year for which the income is reported which would result in the individual overpaying taxes had the error not occurred.  The amount of Roth deferral not reported as taxable could decrease and individual's marginal tax rate resulting in a larger amount of unpaid taxes.

If a correction happens to involve a plan fiduciary, company executive or HCE and the correction resulted in less taxes than should have been paid, then that individual's correction and the plan would be looked upon unfavorably by the regulators.  This could expose the individuals involved and the plan to more serious issues tied to fiduciary responsibility, to nondiscrimination or to tax avoidance.

Conceivably, the plan may want to try to characterize the correction as an Eligible Inadvertent Failure.  However, the EIF rules generally are designed to encourage self-correction, but they are not designed to allow a plan to make up its own correction method.  Given that the IRS has a prescribed correction, it makes sense to follow it.

A mistake happened.  Own it, follow the rules, fix it, take steps to prevent it from happening again, and know steps were taken to protect the plan and the individual's involved.

6 hours ago, justanotheradmin said:

In addition to the standard options provided by the IRS website, what about having the plan issue 1099-R showing the amounts (base amounts) as taxable?  as an in-plan Roth conversion

Then the recordkeeper also recodes the earnings as Roth as a corrective actions. 

Advantages:

The participant's tax situation is pretty much what it would have been

The plan is the position it would have been

no need to redo any W-2s. 

Disadvantages

Tax returns might need to be redone depending on what year the 1099-Rs are for

it isn't quite the same method the IRS provides

Thank you!  I think this a great idea.  The payroll company I client used said it was too late to amend the W-2s for 2022 when this first came up in April 2023.  So, it kind of got left...then of course I'm working on 2023 and I realize it continued and 2022 was still left uncorrected.  

Paul makes good points, and I do think the IRS's correction methods should be followed. 

Tacking it on to this year's W-2, which is an allowable method, means the custodian doesn't have to be involved, since in this case the deposits were coded as Roth from the start. So not having to deal with a 1099-R, and keeping the plan's work to a minimum seems best. It was the employer's mistake, so the employer having to do the heavy lifting to fix/udpate/adjust a W-2, seems fair. And the employer is allowed to pay the employee extra to allow for any extra tax liability, to make them whole. 

Plus, depending on the recordkeeper, or whoever does the 1099-R, their head might explode if they are asked to prepare one but there is no corresponding transaction showing pre-tax amounts being recoded as Roth. 

On 6/25/2024 at 11:57 AM, Paul I said:

From the point of view of recordkeeping, treating the amounts posted in the system as pre-tax and accounting for the correction as if an in-plan Roth rollover occurred is creative and gets the plan accounting close to what should have happened, but consider some of the other potential implications of of this approach.

The impact on the personal taxes for each individual could vary significantly.  The amount of Roth deferral reported as taxable on a W-2 could increase an individual's marginal tax rate for the year for which the income is reported which would result in the individual overpaying taxes had the error not occurred.  The amount of Roth deferral not reported as taxable could decrease and individual's marginal tax rate resulting in a larger amount of unpaid taxes.

If a correction happens to involve a plan fiduciary, company executive or HCE and the correction resulted in less taxes than should have been paid, then that individual's correction and the plan would be looked upon unfavorably by the regulators.  This could expose the individuals involved and the plan to more serious issues tied to fiduciary responsibility, to nondiscrimination or to tax avoidance.

Conceivably, the plan may want to try to characterize the correction as an Eligible Inadvertent Failure.  However, the EIF rules generally are designed to encourage self-correction, but they are not designed to allow a plan to make up its own correction method.  Given that the IRS has a prescribed correction, it makes sense to follow it.

A mistake happened.  Own it, follow the rules, fix it, take steps to prevent it from happening again, and know steps were taken to protect the plan and the individual's involved.

Thanks for your insight, Paul.  The employer is not able to amend the W-2s - the payroll company they used wouldn't allow them to, so option 1 of the IRS corrections is not available.   

The second method (underlined below) - Since the deposits were actually made into the Roth source in 2022 and 2023, the only way I can see to include this in their income in the year it was transferred (2022 and 2023) would be to issue Form 1099-Rs (since the payroll company will not amend the W-2s).  That still leads back to the participants forced to amend their taxes for 2022 and 2023.  

The employer includes the amount transferred from the pre-tax to the Roth account in Marcie’s compensation in the year it’s transferred (2014). If the employer elects, it may compensate Marcie for the additional amount she owes in income tax in 2014. This must be included in Marcie’s 2014 income.

There is nothing to transfer since the deposits occurred to the correct source during that year. But 2024 is the year of the correction, so showing it on this year's W-2 would be an appropriate way to do it, given the IRS's wording. EPCRS is generally flexible on these types of correct matters and showing an adjustment for the year of the correction, rather than going back to a prior year, is often a reasonable approach. 

Then no prior tax years need to be amended. The amount from the prior years, plus any bonus the employer gives to account for the mis-hap would be on the 2024 W-2. 

Or if they are going the 1099-R route (less ideal) the 1099-R could be issued for 2024. 

22 minutes ago, justanotheradmin said:

There is nothing to transfer since the deposits occurred to the correct source during that year. But 2024 is the year of the correction, so showing it on this year's W-2 would be an appropriate way to do it, given the IRS's wording. EPCRS is generally flexible on these types of correct matters and showing an adjustment for the year of the correction, rather than going back to a prior year, is often a reasonable approach. 

Then no prior tax years need to be amended. The amount from the prior years, plus any bonus the employer gives to account for the mis-hap would be on the 2024 W-2. 

Or if they are going the 1099-R route (less ideal) the 1099-R could be issued for 2024. 

Thanks for clarifying!  I guess I misinterpreted the IRS correction.  As you said, no transfers need to occur, since the employer did deposit the $$ to the Roth as the participants requested. Thanks for your help!

I cannot believe this - but I have TWO more clients that have had this happen.   One informed their payroll company and asked for the W-2 to be corrected and they told her it was too late.  So I sent the link to the IRS website for the second option to correct for 2025.  

I just have a couple of questions operationally:

1. I assume I count the deferrals as Roth as they were intended to be although the 2024 W-2 shows as pretax (this throws off my balancing to the W-2s, which drives my OCD crazy). 
2. When the payroll company adds to the 2025 W-2, I assume it's only added to Box 1 because it's already in Box 3 and 5 for 2024, correct?  Otherwise, they would be paying SS and Medicare twice.  
3. This will throw my numbers off for 2025, so I guess I just have to make notes that Box 1 will be overstated by the Roth amount.  Any suggestions?

Thanks!