Excess Allocations vs. Inadvertent Overpayments After SECURE 2.0

“Everybody Makes Mistakes, Everybody Has Those Days”…

Excess Amounts- Retirement plan provisions regarding eligibility, how to count hours of service, contributions, the definition of compensation, automatic enrollment, etc. require so much detailed recordkeeping and coordination between payroll personnel, HR, and the plan’s service providers, that the probability that a plan sponsor will allocate too much money, or not enough, to a participant’s retirement account is very high.

When excess amounts allocated to participant accounts are still in the plan when the error is caught, the plan sponsor will generally correct the operational failure by:

1. forfeiting employer sources and/or
2. distributing salary deferrals to be reported by the participant as income subject to taxes, but not penalties.

Excess amounts still in the plan must be corrected by taking the funds out of the participant accounts, except for deminimis errors.

However, excess allocation errors are sometimes detected after the participant has already received a distribution of the excess amounts. This is called an Overpayment Failure.

Overpayment Failures

Overpayment failures include:

• distributions of excess allocations to a participant,
• distributions in excess of the participant account balance or vested balance,
• ineligible hardship
• a terminating distribution without a distributable event.

In 31 years of auditing retirement plans, our distribution tests have uncovered all the following ineligible or excess distributions:

• Hardship reason not met: A participant doesn’t have a hardship as defined by the plan, but the sympathetic employer wanted to help them with their car repairs, credit car d bills, etcetera.
• Inaccurate ADP/ACP test: The discrimination testing was run with an inaccurate census and the refunds to the HCEs were too large.
• A change in recordkeeper or plan merger resulted in all transferred funds being allocated to the rollover source, leading to the distributions that wouldn’t have been available had the funds been allocated to the correct sources (participants can withdraw their rollover accounts at any time).
• A payroll person enters a termination date for him or herself into the web station and requests a terminating distribution, while still working for the employer.
• Employee transfer to another location coded as termination on the payroll, leading to an ineligible terminating distribution.
• Incorrect Source: A plan sponsor approves a hardship distribution from sources not permitted by the plan document.
• Vesting schedule disregarded and partially vested participants receive fully vested distributions.

In every case, our well-meaning client’s initial reaction is inevitably: “The money is gone, what do we do now?” Well, if the error is an eligible inadvertent overpayment failure, the answer could be…Do Nothing! Let It Be!

Eligible Inadvertent Overpayment Failures: Defined

Section 305(e) of SECURE 2.0 defines an eligible inadvertent failure as an error that occurs despite the existence of practices and procedures that strive to achieve compliance. Inadvertent overpayment failures must relate to:

1. payments that exceed amounts owed to the participant under the terms of the plan or the Internal Revenue Code, or
2. payments made before a distribution is permitted under the terms of the plan.

When the overpayment violates the Internal Revenue Code, such as the Section 402(g), 415, and 401(a)(17) limits, rather than just disregarding the terms of the plan, the distribution is not considered an eligible inadvertent failure, and the employer must:

1. Attempt to recoup the funds from the participant
2. Inform the participant that the overpayment is not eligible for rollover

Similarly, overpayments to disqualified persons under Internal Revenue Code Section 4975(e )(2) cannot be considered eligible inadvertent benefit overpayments. Disqualified people include:

• fiduciaries,
• owners of the company and their relatives (spouse, ancestor, lineal descendants and their spouses),
• officers,
• directors,
• 10% or more shareholders or partners,
• sole proprietors, and
• highly compensated employees who earn more than 10% of the total wages of the employer.

Eligible Inadvertent Overpayment Failures: Correction Relief

IRS Notice 2024-77 provides that if the overpayment is an eligible inadvertent failure, the plan sponsor does not have to seek repayment from the participant. Even if the employer takes no further action, the overpayment can be deemed to be corrected, even if the participant rolled it over to an IRA or another qualified plan. Hence, the participant does not owe any excise taxes for an ineligible rollover.

If the plan sponsor reallocates forfeitures, or the plan’s funding is subject to minimum funding requirements, the employer should make the plan whole by contributing the amount of the overpayment to the plan, so as not to negatively impact other participants by not attempting to recoup the overpayment from the participant.

If the plan sponsor chooses to pursue a reimbursement from the participant, and the participant is unable to repay, the distribution will be considered ineligible for rollover. If the participant completed a rollover to an IRA, excess contributions to the IRA will be subject to a 6 percent excise tax for every year the money remains in the IRA. The notice provided to the participant regarding tax treatment of the unreturned portion of the overpayment may be combined with a recoupment request.

The plan sponsor may also choose to amend the plan retroactively to increase the past benefit available to the participant or decrease the future benefit payments to the affected participants in order to adjust for inadvertent benefit overpayments. An amendment to increase past benefits cannot result in a different violation, such as exceeded limits and cannot reduce anyone’s accrued benefit, which would be inconsistent with an overpayment.

Ignore the Overpayments, but Correct the Underpayments

• Nothing in EPCRS Rev Proc 2021-30 or IRS Notice 2024-77 eliminates the requirement for the employer to make a participant whole when the participant account did not receive enough of a contribution allocation or when there was an overpayment. In fact, EPCRS specifically states that “corrective contributions are required to be made with respect to a current or former participant, without regard to the amount of the corrective contributions. “ Estimates are permitted when it is impractical or impossible to compute an exact correction, as discussed in the next section.
• Exceptions to a correction requirement apply only when participants receive more money than they should have, either because they are eligible inadvertent overpayment failures, discussed above, or because they are deminimis overpayments applicable to overpayments to disqualified persons, or overpayments that are a violation of the Internal Revenue Code.

Rev. Proc. 2021-30 Quotes Regarding Correction Exceptions

• Recovery of small Overpayments. Generally, if the total amount of an Overpayment to an Overpayment recipient is $250 or less, the Plan Sponsor is not required to seek the return of the Overpayment from the Overpayment recipient. Also, the Plan Sponsor is not required to notify the Overpayment recipient that an Overpayment of $250 or less is ineligible for favorable tax treatment accorded to distributions from the plan (and, specifically, is ineligible for tax-free rollover)
• Delivery of small benefits. If the total corrective distribution due a participant or beneficiary is $75 or less, the Plan Sponsor is not required to make the corrective distribution if the reasonable direct costs of processing and delivering the distribution to the participant or beneficiary would exceed the amount of the distribution. This section 6.02(5)(b) does not apply to corrective contributions.
• Corrective contributions are required to be made with respect to a current or former participant, without regard to the amount of the corrective contributions.
• Reasonable estimates. If either (i) it is possible to make a precise calculation but the probable difference between the approximate and the precise restoration of a participant’s benefits is insignificant and the administrative cost of determining precise restoration would significantly exceed the probable difference or (ii) it is not possible to make a precise calculation (for example, where it is impossible to obtain plan data), reasonable estimates may be used in calculating appropriate correction.
  • For example, EPCRS indicates that if it is not feasible to make a reasonable estimate of what the actual investment results would have been, a reasonable interest rate may be used. Thus, if the probable difference between an approximate determination of Earnings and a determination of estimated earnings is insignificant, then the administrative cost of a precise determination would significantly exceed the probable difference, reasonable estimates may be used in calculating the appropriate Earnings. For this purpose, a determination of Earnings made in accordance with the rules of administrative convenience is treated as a precise determination of Earnings. Please refer to our previous blog for a discussion of the available earnings calculation options.
  • It is not clear whether the DOL would agree with the use of the DOL calculator outside of its own VFCP and self-reporting parameters, but EPCRS states that “the interest rate used by the Department of Labor’s VFCP Online Calculator is deemed to be a reasonable interest rate. For more details on the DOL’s new VFCP for late deferrals, please refer to our previous blogs:
    • New Voluntary Fiduciary Correction Program
    • New VFCP on Late Deposit

Administrative Simplicity Often Trumps Perfection

In most cases, plan sponsors choose to Let the Bygones be Bygones and let participants who received eligible inadvertent overpayments keep the extra money. Unless the overpayment amounts are significant, attempting to recoup the money from participants who likely already spent it, distributing notices, undoing previous rollovers to IRAs, explaining the tax consequences of the ineligible distributions, etc., is a drain on valuable administrative time and resources that would be better spent ensuring a timely Form 5500 filing and financial statement audit. In our experience, clients choose administrative simplicity over perfection, and they let participants keep the money.