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SARSEP Fix-It Guide - Employee elective deferrals exceed the IRC Section 402(g) limit for the calendar year ($17,500 in 2014) and excess deferrals haven’t been distributed

Mistake Find the Mistake Fix the Mistake Avoid the Mistake
5) Employee elective deferrals exceed the IRC Section 402(g) limit for the calendar year ($17,500 in 2014) and excess deferrals haven’t been distributed Inspect deferral amounts for plan participants to ensure that they haven’t exceeded the limits. Two possible correction methods
a. Distribution method
b. Retention method
Have sufficient payroll information to verify that the deferral limitations of IRC Section 402(g) were satisfied.

Limit on employee elective deferrals: The most a participant can choose to defer for the 2014-calendar year is the lesser of:

  1. 25% of the participant’s compensation or
  2. $17,500

The dollar limit (subject to cost-of-living adjustments) applies to the total elective deferrals the employee makes for the year to the SARSEP and any:

  • Cash or deferred arrangement (401(k) plan),
  • Salary reduction arrangement under a tax-sheltered annuity plan (403(b) plan), or
  • SIMPLE IRA plan.

Catch-up contributions: A plan may permit participants who are age 50 or over at the end of the calendar year to make additional elective deferrals. These additional catch-up contributions aren’t subject to the above general limits. If your plan provides for catch-up contributions, then all eligible participants must have the opportunity to make the same election for catch-up contributions.

The limit on catch-up contributions for 2014 is the lesser of $5,500 (subject to cost-of-living adjustments) or the excess of the employee’s compensation over elective deferrals that are not catch-up contributions.

Excess deferrals: The law considers amounts deferred for a year in excess of the above limits “excess elective deferrals.” An employee may have excess elective deferrals even if the amount the employee deferred under this SARSEP alone doesn’t exceed the limit. This could happen if an employee who elects to defer compensation under a SARSEP also participates in another plan with elective deferrals that is sponsored by the same or a different employer.

When an employee exceeds the annual limit, the employee must withdraw those excess deferrals and associated income by April 15 following the calendar year to which the deferrals relate. Income earned on excess elective deferrals for the year contributed is includible in the employee’s income in the year it is withdrawn from the IRA.

Deferrals not withdrawn by April 15 - the SARSEP contributions will be subject to the IRA contribution limits ($5,500 in 2014; $6,500 if age 50 or over) and may be considered excess contributions to the employee’s IRA. For the employee, these excess elective deferrals are subject to a 6% tax on excess contributions under Internal Revenue Code Section 4973. If the participant withdraws the excess elective deferral and related income after April 15 and isn’t age 59½, it may be subject to the 10% tax on early distributions.

How to find the mistake:

Inspect payroll records and participants’ year-end deferrals to ensure that they haven't exceeded the limits.

How to fix the mistake:

Corrective action:
When there is a deferral in excess of the Internal Revenue Code Section 402(g) or 408(k)(6)(A)(iii) limit, you have until April 15 of the calendar year after the year in which the excess occurred to correct it. After that, you must use VCP. To correct, the plan sponsor may effect distribution of the excess amount, adjusted for earnings through the date of correction, to the affected participant. The affected participant must include the amount distributed in his or her gross income in the year of distribution. Each distribution must be reported on Form 1099-R for the year of distribution. In addition, you must inform affected participants that this distribution of an excess amount is not eligible for tax-free rollover.

As an alternative, you may use the Retention of Excess Amounts method (see Mistake #4). If you retain an excess amount in the SARSEP plan, you are subject to a special fee in addition to the VCP submission fee. You aren’t entitled to a deduction for an excess amount retained in the SARSEP plan.

If the total excess amount in your SARSEP plan, whether attributable to elective deferrals or employer contributions, is $100 or less, you aren't required to distribute the excess amount and the special fee doesn’t apply.

Example:
Employer X maintains a SARSEP. For calendar year 2012, Bill defers $19,000 to the plan. Bill is under age 50, so he is not eligible to make catch-up contributions. Bill has excess deferrals of $2,000 because $17,000 is the maximum amounted permitted for 2012 ($19,000 - $17,000 = $2,000). Employer X didn't discover this mistake until after April 15, 2013. On November 1, 2013, X effected distribution of the excess deferral (plus applicable earnings of $100, totaling $2,100) to Bill.

Reasonable correction:
For 2012 (year of deferral), Bill must include the $2,000 in gross income. For 2013 (year of distribution), Bill must include the $2,100 distribution in gross income. This amount would be shown on a Form 1099-R for each year, and Bill, because he is under age 59 ½, must pay the 10% early distribution tax.

Correction programs available:

Self-Correction Program:
When correction of this type occurs timely, SCP may be used provided the other eligibility requirements of SCP were satisfied and practices and procedures were in place. 

The example illustrates a situation in which Employer X can’t use SCP because correction didn’t occur within the period required by the Revenue Procedure. VCP must be used to correct the mistake.

Voluntary Correction Program:
Under VCP, correction is the same as described under “Reasonable correction.” Employer X files a VCP submission according to Revenue Procedure 2013-12, using the model documents, including Schedule 3 and Forms 8950 and 8951.The fee for the VCP submission is $250. If Employer X chooses to retain the excess amounts in participants’ SEP- IRAs, an additional compliance fee equal to 10% of the excess amounts will apply.

Audit Closing Agreement Program:
Under Audit CAP, correction is the same as described above under “Reasonable correction.” Employer X and the IRS enter into a closing agreement outlining the corrective action and negotiate a sanction based on the maximum payment amount.

How to avoid the mistake:

Determine the 402(g) limits for each year and monitor participants’ deferrals throughout the year to ensure that no excess amount is placed into a participant’s SEP-IRA.

SARSEP Fix-It Guide
SARSEP Plan Overview
EPCRS Overview
IRA-Based Plans Additional Resources

IRS.gov / Retirement Plans / Correcting Plan Errors / Fix-It Guides / SARSEP Plan Fix-It Guide / Potential Mistake

Page Last Reviewed or Updated: 04-Nov-2014