Due to a glitch in our payroll system, one of the participants in our 401(k) plan contributed more than the IRS limit last year. It came to light while she was preparing her individual income tax return, and she is now asking us to return the excess amount to her?
Are we required to return the extra amount to her? If so, is there a deadline?
There are a number of variables at play here, so unfortunately, we can't really even start with an “easy” answer.
Let’s start with some quick background for context. The IRS imposes a limit on the amount an individual can defer in a single year. For 2018, the limit is $18,500 for those under age 50 and $24,500 for those age 50 or older. The limit is indexed for inflation, so it can increase (in $500 increments) from one year to the next. This is an individual tax limit, so all of a participant’s deferrals to all 401(k) and 403(b) plans are combined when applying it. Any amounts exceeding the limit are called excess deferrals—creative naming, we know. We should also note that even though this is an individual limit, there is a plan-level requirement to enforce the limit. This will make more sense later.
Correcting excess deferrals is where the “fun” begins. The variables that impact the corrections are whether all deferrals were made to the same plan or separate plans and when the excess is identified. For these purposes, if one company or group of related companies sponsors multiple plans, they are considered a single plan.
We will walk through the corrections using some quick examples. We will assume that Jane is 45 years old and deferred $20,000 in 2017. The 2017 limit for someone under the age of 50 is $18,000, so Jane as excess deferrals of $2,000. Let’s also assume that investment earnings related to that excess total $100.
If Jane made all her deferrals to a single plan, the correction is straight-forward. For starters, it is the company’s responsibility to correct the excess, not Jane’s. That is because the company failed to properly enforce the limit. From there, it is a simple matter of distributing the $2,100 (excess plus related earnings). The timing of the corrective distribution dictates how it is taxed.
- On or before December 31, 2017. Jane treats the entire $2,100 as taxable income for 2017
- Between January 1 and April 15, 2018. Jane treats $2,000 as taxable income for 2017 and $100 as taxable income for 2018.
- After April 15, 2018. Jane treats $2,000 as taxable income for 2017 and $2,100 as taxable income for the year of the actual corrective distribution.
Yes, you read that third bullet point correctly. If the corrective distribution is not paid by April 15 of the year following the year of the excess, the excess deferral amount is taxed twice. Not good.
Now, let’s assume Jane changed jobs in the middle of 2017, so she deferred $10,000 each to her two employer’s plans. Since Jane did not exceed the limit in either plan, neither plan failed to enforce the limit. As a result, the burden to correct the excess now falls on Jane. The total amount of the corrective distribution is still $2,100, but Jane must choose which plan will distribute that amount. The distributing plan should obtain sufficient documentation to confirm the amount of the excess and that Jane isn’t just trying to gain access to her account.
Timing, again, becomes a factor. The first two bullet points are the same as above, but things get a bit convoluted if the corrective distribution is not made by April 15, 2018. The taxation is the same, but the corrective distribution is not allowed to be paid. In other words, Jane must report the $2,000 excess as taxable income for 2017; however, the full $2,100 must remain in the plan until Jane is otherwise allowed to take a distribution from her account, e.g. on termination of employment. At that time, she pays income tax on the full amount of the distribution (including the excess).
There is one additional wrinkle that applies when deferrals are made to separate plans. Many plan documents include a provision that would require Jane to notify them of the excess deferral and request a corrective distribution well in advance of the April 15 correction deadline, e.g. notification by April 1. If your plan includes such a provision and Jane requests the corrective distribution on, say, April 7, it would be a violation of the plan document to pay the distribution even though there might still be time to get it done by April 15.
As if all of this isn’t already enough to make your head spin, it is important to note that the deferral limit is always applied using the calendar year regardless of what the plan year is. If a plan year runs from July 1, 2017 through June 30, 2018, Jane could defer $10,000 in the second half of 2017 and the same amount in the first half of 2018. That would put her at $20,000 for the plan year but still well under the deferral limit for both calendar years, so she would not have any excess deferrals.