You have put extra effort into promoting the benefits of saving for retirement, and you are excited to hear that several of the participants in the 401(k) plan have greatly increased their deferral percentages, with the goal of maximizing their contributions to the plan. Of course this is great news, but is it possible that the participants could elect to save too much?
Elective deferrals: Internal Revenue Code Section 402(g) limits the amount of elective deferrals a plan participant may exclude from taxable income each calendar year. This is commonly referred to as the “402(g) limit.” For a plan to be qualified, it must provide that the amount of elective deferrals for each participant under all plans of the same employer for a plan year may not exceed the 402(g) limit for the plan year. The 402(g) limit for 2015 is $18,000; however, this limit is subject to cost-of-living increases for later years.
Catch-up contributions: A plan may also permit participants who will be at least age 50 by the end of the calendar year to make additional deferrals. These additional deferrals are called “catch-up contributions.” Catch-up contributions are not subject to the general limits (i.e. total contributions) that apply to 401(k) plans and do not count towards the 402(g) limit. However, there is a separate limit on catch-up contributions each year. The limit on catch-up contributions for 2015 is $6,000; however, this limit is also subject to cost-of-living increases for later years. An employer isn’t required to provide for catch-up contributions. However, if your plan allows catch-up contributions, you must allow all eligible participants to make catch-up contributions.
Elective deferrals include both pre-tax deferrals and designated Roth contributions. Generally, you must consider all elective deferrals made by a participant to all plans in which the employee participates to determine if the employee has exceeded the deferral limits. If an employee has elective deferrals in excess of the 402(g) limit (and the catch-up limit, if applicable) under one or more plans of the same employer, each plan is subject to disqualification. However, an employer is not responsible for knowing about contributions made by the participant to other employers’ 401(k) plans during the year.
Your plan document may impose its own lower limit on the deferral amount or on the percentage of pay that participants may defer. Additionally, your plan may need to limit a plan participant’s elective deferrals to meet certain nondiscrimination requirements.
If the total of a plan participant’s elective deferrals (including catch-up contributions, if applicable) for a calendar year exceeds the 402(g) limit plus the catch-up contribution limit, if applicable (for 2015, $18,000 plus $6,000), the excess amount is referred to as “excess deferrals.” These “excess deferrals” plus allocable earnings must be distributed to the participant by April 15 of the year following the calendar year of the deferrals. Excess deferrals not timely returned to the participant are subject to additional tax.
The following describes the differences between timely distribution and late distribution of “excess deferrals:”
Timely Distribution of Excess Deferrals (by April 15)
- Excess deferrals distributed from the plan by April 15 of the year following the year of deferral are taxable in the calendar year deferred.
- Earnings are taxable in the year they are distributed.
- There is no 10% early distribution tax, no 20% withholding and no spousal consent requirement for amounts timely distributed.
Consequences of a late distribution (after April 15)
- If the excess deferrals aren’t distributed from the plan by April 15, each affected plan of the employer is subject to disqualification and would need to go through the IRS Employee Plans Compliance Resolution System (“EPCRS”) to correct the operational error.
- Under EPCRS, these excess deferrals are subject to double taxation; that is, they’re taxed both in the year contributed to the plan and in the year distributed from the plan.
- These late distributions could also be subject to the 10% early distribution tax, 20% withholding and spousal consent requirements.
How to find the mistake:
Ensure that no participant’s elective deferrals exceed the 402(g) limit (and the catch-up limit, if applicable) for a year by comparing the amount deferred to the limits for the year. If a participant exceeds the limits and the excess deferrals are not corrected, the plan could be disqualified.
How to fix the mistake:
There is a 10% additional tax for distributions that don’t meet an exception, such as death, disability or attainment of age 59 ½, among others. To avoid this additional tax (commonly referred to as the “10% early distribution tax”), correct excess deferrals no later than April 15 of the following year. If you don’t correct by April 15, you may still correct this mistake under EPCRS; however, distribution may be subject to the 10% early distribution tax.
Under EPCRS, the permitted correction method is to distribute the excess deferral to the employee and to report the amount as taxable both in the year of deferral and in the year distributed. These amounts are reported on Form 1099-R.
Employer X maintains a 401(k) plan that has 21 participants. For calendar year 2014, Ann deferred $18,500 to the plan. Ann is under age 50 and isn’t eligible to make catch-up contributions. Ann has excess deferrals of $1,000 because $17,500 is the 402(g) maximum amount permitted for 2014. Employer X didn’t discover this mistake until after April 15, 2015. On November 1, 2015, Employer X distributed the excess deferral (plus earnings of $100, totaling $1,100) to Ann.
For 2014 (year of deferral), Ann must include $1,000 in gross income. For 2015 (year of distribution), Ann must include $1,100 in gross income. Employer X would report this amount on Form 1099-R. In addition, Ann must pay the additional 10% early distribution tax.
Correction programs available:
The above example shows an operational problem because Employer X failed to follow the plan terms prohibiting any employee’s elective deferrals from exceeding the 402(g) limit. If the other eligibility requirements of SCP are satisfied, Employer X may use SCP to correct the failure.
- No fees for self-correction.
- Practices and procedures must be in place.
- If the mistakes are significant in the aggregate:
- Employer X needs to make a corrective distribution by December 31, 2016.
- If not corrected by December 31, 2016, Employer X isn’t eligible for SCP and must correct under VCP.
- If the mistakes are insignificant in the aggregate, Employer X can correct beyond the two-year correction period that applies to significant errors. Whether a mistake is insignificant depends on all facts and circumstances.
Voluntary Correction Program:
The correction method for the above example is the same under VCP as it is under SCP. The difference is that Employer X must also make a VCP submission to the IRS according to the IRS correction program under Revenue Procedure 2013-12. The IRS recently issued modifications to the IRS correction program in Revenue Procedure 2015-27 and Revenue Procedure 2015-28. The fee for the VCP submission is $1,000 (because Employer X’s plan has 21 participants).
When making its VCP submission, Employer X must include Forms 8950 and 8951 and, if Employer X chooses to use a “model” VCP format to prepare its VCP submission (which is very common), Employer X must use the new model documents (Form 14568 and, if appropriate, one or more Schedules 14568-A through 14568-I) for VCP submissions (which replaced the Appendices included at the end of Revenue Procedure 2013-12).
Audit Closing Agreement Program:
Under Audit CAP, correction is the same as under SCP. Employer X and the IRS enter into a closing agreement outlining the corrective action and negotiate a sanction based on the maximum payment amount. The sanction will probably be significantly higher that the VCP fee.
Of course, the best plan of action is to avoid the need to use these IRS correction programs by taking steps to ensure that you are correctly administering your plan.
How to avoid the mistake:
- Work with your plan administrator to ensure that the administrator has sufficient payroll information to verify that the 402(g) limit, the catch-up limit, and any other lower limit provided under your plan’s terms is properly applied.
- Establish procedures to ensure that, based on the participant election forms (including modifications), participants won’t exceed the 402(g) limit, the catch-up limit, or any other lower limit provided under your plan’s terms.
- Have checks and balances in place to alert you and your plan administrator when the limits on deferrals are exceeded to take timely corrective action.