Posted By: Maria T. Hurd, CPA, RPA
What if the Participant Already Spent the Overpayment from the Plan?
Ineligible or excess distributions from qualified plans happen all the time. In our last 30 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 card bills, et cetera.
- Inaccurate ADP/ACP test: The discrimination testing was run with an inaccurate census and the refunds to the HCEs were too large.
- A record keeper change or plan merger resulted in all 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 403(b) plan sponsor approves a hardship distribution from earnings on deferrals or from employer contribution sources in a custodial account plan (hardship distributions from 403(b) plans can come from deferrals only).
- 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?” Fortunately, the IRS realizes that, in most cases, a defined contribution plan participant would have eventually been entitled to the distribution anyway, such that the ineligible distribution is effectively a timing difference, and they have provided workable and reasonable correction alternatives through the correction program: Employee Plan Compliance Resolution System (“EPCRS”).
Option 1: Return of Overpayment
The employer takes reasonable steps to have the overpayment repaid to the plan, adjusted for earnings at the plan’s earnings rate from the date of the distribution to the date of the correction of the overpayment. In defined contribution plans, like 401(k) and 403(b) plans, any amount returned to the plan by the participant or beneficiary is allocated to his or her account. However, in most cases, the money is long gone by the time the overpayment is discovered, which leads us to.
Option 2: Amend 1099-R as Necessary
To the extent a participant was not eligible to receive the distribution, it seems reasonable that he or she should not be able to rollover the funds and continue benefiting from favorable tax treatment. To that end, the employer must notify the employee that the overpayment was not eligible for favorable tax treatment and that any direct or 60-day, tax-free rollovers to another plan or IRA must be removed.
Option 3: Make-Whole Contribution
Unlike daily-valued defined contribution plans, ineligible distributions from defined benefit plans and balance-forward defined contribution plans do affect the plan funding and other participants. In those cases, to the extent the participant does not repay the amount of the overpayment adjusted for earnings at the plan’s earnings rate, the employer or another responsible party must contribute the difference to the plan.
Option 4: Retroactive Plan Amendment
A plan does not have an Operational Failure to the extent the plan is permitted to be amended retroactively to reflect the plan’s operations. Operational Failures may be corrected under SCP by adoption of a plan amendment that conforms the terms of the plan to the plan’s prior operations, provided
- The plan amendment would result in an increase of a benefit, right or feature.
- The increase in the benefit, right, or feature applies to all employees eligible to participate in the plan.
- Providing the increase in the benefit, right, or feature to participants is permitted under the Code.
Option 5: Make Someone Else Pay!
The employer or another party can contribute the amount of the overpayment plus earnings to the plan instead of seeking recoupment from the participant or beneficiary. The amount of the overpayment, adjusted for Earnings at the plan’s earnings rate to the date of the repayment, is to be placed in an unallocated account, to be used to reduce employer contributions (other than elective deferrals) in the current year and succeeding years, or, if the amount would have been allocated to other eligible employees who were in the plan for the year of the failure if the failure had not occurred, then that amount is reallocated to the other eligible employees in accordance with the plan’s allocation formula.
Option 6: Do Nothing! Exceptions to Full Correction.
If the participant received an insignificant overpayment, don’t sweat the little stuff. If the total amount of an Overpayment to a participant or beneficiary is $100 or less, the Plan Sponsor is not required to seek the return of the Overpayment from the participant or beneficiary. The Plan Sponsor is not required to notify the participant or beneficiary that the Overpayment is not eligible for favorable tax treatment accorded to distributions from the plan (and, specifically, is not eligible for tax-free rollover).
The same way that the DOL and the IRS want to make sure participants receive all the funds that they are owed, they also want to ensure that they don’t receive more than they should. Employers who issue overpayments greater than $100 should ask the participants to “Give It Back!” and if/when they say they already spent the money, after responding “Ok, Keep It!” employers must reiterate that the amount representing the overpayment can not benefit from favorable tax treatment and must be removed from any tax deferred accounts that accepted a rollover, if applicable. When appropriate, the employer or another party can put the amount of the overpayment in an unallocated amount to be offset against future employer contributions, or they can reimburse defined benefit or balance-forward plans to make them whole. All of it requires time and effort and a small dose of embarrassment for the employer, which can only be avoided by not making the mistake in the first place, or by making a small mistake less than $100, which turn “Give It Back!….Ok, Keep It!” into the best option: “Never Mind!”.