ADP refund question

1/1/2023 to 12/31/2023 ADP test failed. HCE is due an ADP refund of $3,000. The HCE in question took a full in-service distribution in June of 2024. He rolled it over to an IRA. He continued to defer into the 401(k) plan, and has deferred approximately $5,000 from June of 2024 to current date.

When correcting the failed ADP test for plan year 2023, is it permissible to refund the $3,000 based on his current account balance (of the $5k deferred in 2024)? Or does the rollover to the IRA need to designate that $3k was ineligible to be rolled over? 

See the instructions to Form 1099-R. I believe their is a section called something like "Refund after full distribution" that explains what you do.

If I remember correctly you issue two (2) form 1099-Rs, once for the refund and one for the remainder of the distribution. The refund is no eligible for rollover so you need to inform the participant of the amount that was was not eligible for rollover. They will need to coordinate with their IRA custodian to do an Excess IRA contribution withdrawal, including earnings. They'll want it processed from the IRA correctly as a refund of excess IRA contribution and not a regular IRA distribution or they will wind up with two taxable 1099-Rs for the same money. I think just about every IRA custodian will have forms for removal of excess IRA contributions but finding the right person at the IRA custodian to talk to about how to do it can be a challenge.

Thanks Lou. So just to be clear ---- do the regulations prohibit the excess contribution refund (for the 2023 ADP test) to consist of deferrals made in 2024? If all of his 2023 deferrals were rolled over to an IRA, I can certainly understand that. But on the other hand, he has enough in his 401(k) account (from 2024 deferrals) to process the excess contribution refund.

I suggest treating the rollover as a discrete event and applying the rules as if there were no additional deferrals.  Agents tend to frown on netting transactions that get to the same result but do not follow established procedures.  It doesn't help that the participant is an HCE.

The participant apparently is able to take withdrawals from the plan and can restore any amount taken from the IRA by making another rollover from his account. 

If he has funds in his account to process the refund, I would just do it. That's the path of least resistance. Though you may find yourself in the same place when you do 2024 testing. I was assuming he was a former participant who withdrew all his funds.

11 minutes ago, Lou S. said:

If he has funds in his account to process the refund, I would just do it. That's the path of least resistance. Though you may find yourself in the same place when you do 2024 testing. I was assuming he was a former participant who withdrew all his funds.

He's still an employee of the employer. He took an in-service (age 59 1/2) distribution in June of 2024, but then continued to defer into the same 401(k) plan. And now he has built up around $5k into his 401(k) account. 

It just doesn't seem practical that an excess contribution refund to correct a failed 2023 ADP test is going to consist of deferrals that were made from June of 2024 to current date. But those are currently the only deferrals in his account.

Money is fungible. The requirement is to refund out of his account. You don’t have to find the specific dollar that was contributed in 2023. 

1 hour ago, Bill Presson said:

Money is fungible. The requirement is to refund out of his account. You don’t have to find the specific dollar that was contributed in 2023. 

What if all of the deferrals prior to the in-service distribution (including those made in 2023) were pre-tax, but all deferrals made subsequent to the in-service distribution (accounting for his current $5k balance) were Roth. Does that change anything in your opinion?

1 hour ago, roy819 said:

What if all of the deferrals prior to the in-service distribution (including those made in 2023) were pre-tax, but all deferrals made subsequent to the in-service distribution (accounting for his current $5k balance) were Roth. Does that change anything in your opinion?

Probably. Is that the case?

Yes, if the there is no money in the source required to make the refund, that changes the calculus and you are back to my original answer.