Deducted too much pretax

A Participant went on line and changed from 10% to 2%.  

Should the excess be forfeited as a mistake of fact and the Participant made whole outside the plan?

Should it be distributed to the Participant as an excess with the Plan issuing a 1099?

Something is missing.

Thank you Mike. 

Participant went into the website of the Investment company and changed his pretax deduction from 10% to 2%.  This was not picked up by payroll for 2 months, December and January.  So too much was deducted from his paycheck.

He wants the money.

Should the excess be forfeited as a mistake of fact and the Participant made whole outside the plan?

Should it be distributed to the Participant as an excess with the Plan issuing a 1099?

Very messy with one month in a now closed tax year and one month not.  In a perfect world I would say this is a "mistake".  Mistake is a term that implies reversal is possible and that there are no negative tax consequences associated with such reversal.  But you won't find "mistake" in EPCRS which instead leans to "operational error" for such things.  In any event, I'd go with correcting this obvious mistake as simply and cleanly as possible.  If possible at this late date, have a corrected W-2 issued, pull the money out of the plan and give it back, give less back than what was taken in error if there has been a measurable loss, and if so, make up that amount with a payment directly from the employer.  I know.  Heresy.

This is the second post in a couple of days in which someone "went online" or "to the investment company" and changed deferrals.  The first thing I would do is make sure this is a valid way to make a change. 

It's most likely a valid way to make a change.  I'd guess the scenario of passing the information to employer/payroll to make the change is where the hang up is.  I know of a major player in the 401k market that sends a deferral change report to the employer for handling.  The employer has to go in and get the report and pass on.

If the employer doesn't get the report I can see where the deferral doesn't get changed....

Definitely messy.  As Mike indicates, if the W-2 can be adjusted, the deferral would need to go back to the employer (not the participant) with no 1099.  However, if this is an over-allocation not supported by plan provisions (i.e., 10% deduction vs. 2% authorized as deduction), you could still reverse back to the employer for over-deduction correction (with earnings and associated match/earnings adjustment).  If the sponsor & provider decide to refund to participant directly, you may want to review if 1099-R code 'E' should be utilized.

This is an operational error. Failure to follow plan doc. The plan doc says that the participant defers what he elected. They deferred more than he elected. You are within the "by the end of the second full plan year after the plan year in which error occurred" period for self-correction, and anyway probably "insignificant." Your self-correction is to have the plan pay him the amount, plus earnings, and give him a 1099-R for this amount for the actual year of distribution with code E, as stated by CJ Allen. Alternatively, you could pay him/her the money now from company, with earnings, and then treat the excess in the account, including allocable earnings, as if it were a forfeiture, so company can offset against contributions. In the latter case, it would be compensation income to him in the year paid, including the earnings, and reportable in Box 1 of W-2 as such by the employer for the year paid, since he was neither in actual nor constructive receipt of the funds in earlier year when mistakenly contributed. He is a cash basis taxpayer and thus taxable on it when paid. Payment from the trust and reporting on 1099-R using Code E is probably preferable, sinc If you have company pay and report on W-2, a manual intervention in payroll may be required to suppress application of employer and employee FICA to the returned amount (the earnings increment would be subject to FICA), and the discrepancy between Box 1 and the FICA wages box might be questioned by the Service Center.