Employee 401(k) elections conflict with federal income tax withholding elections

We have a client with a lot of employees who elect additional income tax withholding.  The forms provide that employees are to specify the amount of additional withholding per pay period.  However, some employees instead put down a figure that they intend to be their entire year's withholding.  The result is that so little is left in each paycheck that 401(k) deferrals are limited by the absence of any paycheck to defer from.  And surprisingly, this occurs often enough that it's impractical to manually check and fix the issue, and employees sometimes don't notice and correct the error right away.  

Does anyone have any experience with whether it will be treated as a plan qualification error if the client does not withhold and defer the  percentage of compensation elected by the employee because there is not enough money left after taxes from which to deduct the funds? I've heard rumors that this was a JCEB question (never answered) some time back, but have been unable to find it in the online JCEB materials.

Interesting.  I never thought about whether there's a required "order" to these kinds of elections.  Would a comparison to someone wishing 100% deferral despite FICA concerns be of any use in the analysis?

Even without the mistaken withholding instruction you describe, an employer/administrator often might encounter the problem of lacking enough pay for all the things an employee might do with it.

For example, consider a paymaster who must withhold for FICA taxes, three income taxes (Federal, State, and city or county), two or more unemployment and disability taxes, and might apply salary reductions for the employee’s portion for health coverage, a health flexible spending account, a dependent-care account, and a 401(k)/403(b)/457(b) elective deferral.

Some employers develop an internal hierarchy—sometimes written, often not—to sort out these and other competing demands on an employee’s pay.

Most concur that withholding taxes comes before any of the health, other welfare, and retirement benefits.

And within employee benefits, most prioritize maintaining health coverage over voluntary retirement savings.

While I’ve never seen the Treasury or its IRS publish anything on this point, it should be unseemly for the IRS to assert as a tax-disqualifying operational defect an employer/administrator’s failure to apply perfectly an employee’s elective-deferral election if the reason was properly withholding taxes, especially any Federal tax.

About coordinating wage reductions across the many employee benefits and providing it in or under the plans’ governing documents, that’s possible when one law firm works on all plans of the employer.  It’s hard to do using IRS-preapproved and other documents that come from the plans’ service providers.  And even employers that use custom documents for all or most of the plans often don’t want to pay for the time it would take to do this right.

26 minutes ago, Peter Gulia said:

it should be unseemly for the IRS to assert

I like that - a very civilized way of saying it. Nicely put!

We are in the small plan market and we have had an issue when a participant has both 401k deferral contributions and a loan repay.    When the participant doesn't have enough for both after taxes and health benefits, our clients or their payroll company always take the 401k deferral and then apply what's left (if any) to the loan repay.  Makes an already messy process (loans!) even messier.  Again the reasoning is that the employee elected "x" amount or percentage for 401k deferral withholding therefore the payroll company takes that first.  Isn't the loan repayment also an employee elected choice?  I've often thought that the loan repayment should take precedent over the deferral but as previously mentioned have never seen a "formal" hierarchy for deductions and/or guidance of any sort.   Certainly would be helpful.....

pmacduff alludes to a further inquiry:

How many of these decisions are made, practically, by an employer falling-in with the way its payroll-services provider offers services?

18 hours ago, Carol V. Calhoun said:

will be treated as a plan qualification error if the client does not withhold and defer the  percentage of compensation elected by the employee because there is not enough money left after taxes from which to deduct the funds?

Carol, the error would be failing to follow your plan document if it said that you would contribute whatever the employee elected, right? So I guess if you put a provision in the plan document that subordinated the elective deferral to other required or elected withholdings, along the lines of what Peter describes, there would be no issue, right? And I guess even without such a specific provision, if your plan document has general language regarding the authority of the plan administrator to interpret and administer the plan that could be stretched to cover this, i.e., to allow you to do what is practical, you would also be OK, even if a particular IRS agent decided to go "unseemly" on you. Put a plan administrator memo on the action taken in the fiduciary file and date and sign it. Show that to the agent in a couple of years, if there is an exam, and I think you'd be OK.

What Luke Bailey says.

And consider whether it makes sense for an employer/administrator to try to anticipate many situations in which an employee might lack enough pay for all the things one might do with it, develop the employer’s hierarchy, and set it as an interpretation and plan-administration procedure for all the employee-benefit plans.

Carol,

Perhaps you could consider amending the plan (and/or the employee payroll deduction/deferral election forms or the electronic on-screen equivalents) to say that deferrals shall be limited to amounts available after withholding from an employee's pay (for employment taxes, other benefits, etc) so that your plan document matches your informal payroll practice in this regard.

The only guidance I know of that touches upon this is the catch-up regulation under 1.414(v)-1(e)(1)(ii)(B) that says for purposes of meeting the universal availability requirements for catch-ups, an applicable employer plan does not fail to make catch-ups universally available merely because it restricts deferrals of any employee (including a catch up eligible participant) to amounts available after withholding from the employee's pay (e.g., after deduction of all applicable income and withholding taxes). While the context of these regulations is limited to the universal availability of catch-ups, this makes it seem that the IRS is aware of this issue and allows you to limit contributions that would have been made under an election where implementing the election is impractical due to legal restrictions or otherwise wouldn't make sense.  

Best of luck. 

Perhaps things have changed, but every payroll system I have worked with had a set of decisions for every deduction and income element -  if only to get the various determinations correct - include in box 1, definition of covered compensation, ADP wage for testing (which may differ from covered comp).

There always was a  hierarchy.  Very high on the list are  cafeteria plan pre-tax deferrals which are pre tax for fica and fica-med.  401k pretax comes before federal and most state withholding, but not fica and fica-med, nor, oftentimes local income tax withholding.  Roth would generally come after federal and state income tax withholding.

Perhaps things have changed, but every payroll system I have worked with had a set of decisions for every deduction and income element -  if only to get the various determinations correct - include in box 1, definition of covered compensation, ADP wage for testing (which may differ from covered comp).

There always was a  hierarchy.  Very high on the list are  cafeteria plan pre-tax deferrals which are pre tax for fica and fica-med.  401k pretax comes before federal and most state withholding, but not fica and fica-med, nor, oftentimes local income tax withholding.  Roth would generally come after federal and state income tax withholding.

FYI. There is no mention regarding “supplemental withholding” in IRS publication 15 (2021).