401(k) Plan Accepts Invalid Rollover from Roth IRA . . . What Now?

In 2018, participant rolled over $50,000 from an IRA to his 401(k) account.  At the time, the recipient 401(k) plan administrator believed the rollover was from a Traditional IRA.

This week, the 401(k) plan administrator learned the 2018 rollover was from a Roth IRA.  The error was discovered when the participant called and asked why he didn't have a "Roth Rollover Contribution" account balance.  Answer:  Because the plan believed the 2018 rollover was from a Traditional IRA.

The rollover account is now worth $55,000 ($50,000 rollover contribution plus $5,000 earnings)

Treas. Reg. Section 1.401(a)(31)-1, Q&A-14 requires that "the amount of the invalid rollover contribution plus any earnings attributable thereto [be] distributed to the [participant]. . . . "

Two Questions:

(1) I feel there should be guidance on how to report the distribution that will be made to the participant and I'm just not finding it.  Can anyone point to any such guidance?

(2) In the absence of such guidance to the contrary, does anyone see any issues with the following:

     (a)  Distribute $55,000 to the participant.

     (b) The plan has no idea what portion of the $50,000 rolled over amount constituted basis in the Roth IRA (and the plan administrator is not inclined to try to find out what happened 7 years ago, and wants to give the participant the benefit of the doubt from a taxation perspective).

     (c) Even though the Roth dollars have been in the 401(k) plan for more than five years, and the participant is older than 59-1/2, this is not a qualified distribution because the Roth dollars should never have been in the plan in the first place.  Accordingly, the plan will report the $55,000 distribution as consisting of $50,000 non-taxable basis and $5,000 as taxable earnings.

     (d) This is not an eligible rollover distribution.  Therefore, 10% federal income will be withheld from the $5,000 taxable earnings portion of the distribution unless the participant elects a greater or smaller amount of federal income tax withholding.

     (e)  The 1099-R will be coded as an EPCRS distribution (Code "E") as a distribution of an excess amount.

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Any leads or thoughts would be appreciated.  Thanks.

That feels like chopping off your nose to spite your face - have him put it back in a Roth IRA?  (Put the plan back in the position it would have been if the error hadn't happened.)

Bri . . . Thanks for the response.  Just so I understand you correctly, you believe the plan can/should treat this like an ordinary distribution (i.e., permit participant to rollover to a Roth IRA, or receive a cash distribution that constitutes a qualified distribution)?

Thanks again.

I think if you want to do this with IRS blessing since it well past the 2 year self correction mark, you would be looking at VCP with the suggested correction be that the plan disgorge the funds back to a ROTH IRA  since it was not supposed to accept rollover funds from a ROTH  IRA in the first place.  Assuming the participant can provide the documentation that the funds did actually come from a ROTH IRA originally.

What documentation did the Plan get in 2018 to suggest that it was from a traditional IRA and an allowable rollover in?

Side note: $5k gain in 7-8 years? Yikes!

I agree with Lou - I hadn't noticed we were outside the SCP window.

When was the failure (if any) described above IDENTIFIED by the plan’s sponsor/administrator?

Isn’t this the kind of thing that can now be self corrected at any time under SECURE 2.0? I’m not sure but I thought you would be able to.

Even if all other conditions for self-correction are met, the correction must be “within a reasonable period after the failure was identified.” The IRS’s Notice sets up that “a failure that has been corrected by the last day of the 18th month following the date the failure is identified by the plan sponsor will be treated as having been completed within a reasonable period after it is identified.”

All -- Thanks for your responses.

To answer questions:

Lou S/Bri -- The plan administrator is expected to take the position that this is an eligible inadvertent failure under SECURE 2.0 that can be corrected pursuant to IRS Notice 2023-43, Q&A-8.

Lou S -- In researching the matter, the 2018 rollover check indicated it was a rollover from IRA.  The check did not indicate it was from a Roth IRA.  Written plan notes suggest the plan administrator verbally confirmed the rollover came from a traditional IRA.  The participant -- this week -- has presented the plan with documentation that clearly shows the rollover was from a Roth IRA.

Peter -- The error was identified this week when the participant called to inquire why he didn't have a Roth Rollover Contribution balance (Answer:  Because the plan administrator was under the mistaken belief that the rollover came from a traditional IRA).

I believe -- unless there is guidance to the contrary -- that this error can be self-corrected.  I'm just not sure whether the distribution must be made in cash to the participant (i.e., not eligible for rollover; not a qualified distribution?), or whether the plan can treat this as an ordinary distribution and allow the participant to make an affirmative election (i.e., receive a cash distribution or roll back into a Roth IRA).  I was leaning toward a cash distribution pursuant to EPCRS, but Bri has me wondering if the plan can treat this like an ordinary distribution and allow the participant to elect cash or a rollover to the Roth IRA). . . . And I have not found guidance in helping with this issue.

Thanks all for any additional thoughts.

Is the plan administrator insistent on distributing the account? Because it seems to me that the simplest correction would be to keep it in the plan and adjust the plan's recordkeeping so that it is correctly coded as a Roth rollover.

If the issue is that the plan does not permit Roth rollover contributions, then I would look at doing a correction by retroactive amendment to allow Roth rollover contributions back to 2018. In that case, self-correction* would be fine if the participant is a NHCE, but I would want the reliance of VCP if the participant is a HCE to make sure I did not inadvertently create a benefits, rights or features failure.

* If self-correcting by amendment, I would be ok with treating this as an insignificant failure that can be corrected at any time, because it a) only affected one participant, b) involved an amount of money that is presumably small in relation to total plan assets, and c) has no tax consequences since there has not been a distribution.

C.B.

The problem is that a Roth IRA was rolled over to a Roth 401(k) . . . Which I understand to be prohibited by law and that the error must be distributed to the participant pursuant to 1.401(a)(31)-1, Q&A-14.  I don't see there is any discretion to simply recharacterize as a Roth Rollover Contribution and keep it in the plan.

Thanks.

I had to look it up on the IRS chart, and yup Roth IRA's cannot be rolled to Roth 401k accounts. Wicked dumb but there it was.

Excellent point. In that case, I might still try to allow it to stay in the plan, but only with a VCP.

And if the client insists on self-correcting and not going through VCP?

Forced cash distribution to participant pursuant to EPCRS?

Give participant election to rollover to a Roth IRA if he wants?

I cant imagine the right answer to the plan sponsor making a mistake is to force the rollover to be cashed out. Return the funds to where they came from, a Roth IRA. Thats the correction. And for something as straightforward as this I would argue it is an eligible inadvertent failure.  I know the IRS gave some guidance o nwhat that means and I confess I did not read it before posting this, but by golly this has to fit in there.

Austin -- Thanks.  You and Bri have convinced me to work with the participant to have the amount distributed to a Roth IRA.

Regarding the prohibition of rolling over a Roth IRA into a Roth 401(k), I think that rule existed because under the Roth 401(k) rules, lifetime RMDs were required. Now that the requirement for lifetime RMDs for Roth 401(k) balances has been repealed, that prohibition has outlived its initial usefulness. This is something that should be included in SECURE 3.0. (House Way & Means Committee Members: take note!) If you go through VCP, based on the current state of the law, I stongly doubt that the IRS would let you keep the money in the plan.