Consequences to a Participant Who Makes Excess Deferrals to a 401(k) Plan
IRC Section 402(g) limits the amount of elective deferrals a participant may exclude from taxable income in a calendar year. This Snapshot examines the consequences to a participant who makes excess elective deferrals to a 401(k) plan.
IRC Sections and Treas. Regulations
- IRC Section 401(a)(30)
- IRC Section 402(g)
- IRC Section 414(v)
- Reg. Section 1.401(a)-30
- Reg. Section 1.402(g)-1
- IRM 4.72.2
- Pub. 7335, Alert Guidelines 12, Section 401(k) Requirements
- 401(k) Fix-It Guide: Elective deferrals weren't limited to the amounts under IRC Section 402(g) for the calendar year and excesses weren't distributed
Limitation on elective deferrals
IRC Section 402(g) limits the amount of elective deferrals a participant may exclude from taxable income in the participant’s taxable year. The Code and Regulations specifically refer to a participant’s taxable year, not the calendar year. However, since the taxable year for most individuals is the calendar year, this Snapshot will refer to the IRC
Section 402(g) taxable year as the calendar year.
The IRC Section 402(g) limits apply to elective deferrals made into various arrangements, including 401(k) plans, 403(b) arrangements, Salary Reduction Simplified Employee Pension Plans (SAR-SEPs) and Savings Incentive Match Plans for Employees (SIMPLE-IRAs). Elective deferrals include both pre-tax salary reduction contributions and designated Roth contributions, which are contributed on an after-tax basis. See Reg. Section 1.402(g)-1(b)(5). A participant must aggregate all elective deferrals contributed to all of the plans in which he or she participates to determine if the IRC Section 402(g) limit has been exceeded.
Deferrals in excess of the IRC Section 402(g) limit (which cannot be applied as IRC Section 414(v) catch-up contributions discussed below) are called “excess deferrals.” See Reg. Section 1.402(g)-1(e)(1)(iii). Excess deferrals may result in income tax liability to the participant unless they are corrected. Correction for this purpose generally involves distributing the excess deferrals with allocable earnings, which is discussed in more detail below.
Although not the subject of this Snapshot, a plan that does not distribute excess deferrals risks plan disqualification. See IRC Section 401(a)(30) and Reg. Section 1.401(a)-30. Excess deferrals may also impact other operational aspects of the plan, such as ADP testing. See Reg. Section 1.402(g)-1(e)(1)(ii).
Treatment of excess deferrals
Unless timely distributed, excess deferrals are (1) included in a participant’s taxable income for the year contributed, and (2) taxed a second time when the deferrals are ultimately distributed from the plan. See IRC Sections 402(g)(1) and 402(g)(2) and Reg. Section 1.402(g)-1(e)(2). A participant who fails to receive a distribution of the excess deferrals does not receive basis in his pre-tax deferral account equal to the amount of excess deferrals. See IRC Section 402(g)(6).
The amount of the excess deferral will not be taxed twice if a corrective distribution is made. See IRC Section 402(g)(2). The corrective distribution must include the amount of the excess deferrals, along with amounts earned on the excess deferrals during the calendar year during which the deferrals are made without regard to income earned during the “gap period” between the close of calendar year in which the excess contribution was made and the time of actual corrective distribution. See IRC Section 402(g)(2)(A)(ii). Additionally, the corrective distribution must be made be made no later than April 15th following the close of the calendar year during which the excess deferral was made. See IRC Section 402(g)(2)(A)(ii). For example, excess deferrals made during 2016 must be distributed by April 15, 2017. This April 15th deadline is not postponed by extending the filing of the employee's federal income tax return.
To the extent that a corrective distribution is not made within the correction period, the excess deferrals may not be distributed until a distribution is otherwise permissible under the terms of the plan, or the distribution is necessary to avoid plan disqualification under IRC Section 401(a)(30). Reg. Section 1.402(g)-1(e)(8)(iii) provides that distributions of excess deferrals after the correction period may be distributed from a 401(k) plan only when permitted under IRC Section 401(k)(2)(B).
Relationship with the catch-up limitation under IRC Section 414(v)
In determining whether a participant has exceeded the IRC Section 402(g) limit, the participant should take into account any catch-up contributions that the he or she is eligible to make under IRC Section 414(v). In order to receive a catch-up contribution: (1) a plan must provide for catch-up contributions; and (2) a participant must meet the eligibility requirements in IRC Section 414(v). A participant is eligible to receive a catch-up contribution if the participant: (1) is at least 50 years old by the end of the calendar year during which the contribution is made; and (2) the deferrals have been made up to the applicable limit. The applicable limit may be the IRC Section 402(g) dollar limit, the IRC Section 415(c) contribution limit, or the plan’s design-based maximum deferral limit.
If the requirements mentioned above are met, deferral amounts that exceed the IRC Section 402(g) limit will not be treated as excess deferrals to the extent that the amounts are within the catch-up contribution limit described in IRC Section 414(v)(2).Therefore, it will not be necessary to make any corrective distribution to comply with IRC Section 402(g) and/or IRC Section 401(a)(30).
Example: Employer A maintains a 401(k) plan that allows participants to elect to defer up to a maximum of 15 percent of their plan year compensation. The plan year is the calendar year. For calendar year 2015, Participant B elects to defer 15 percent of his compensation. Participant B, a HCE age 40, receives $140,000 of compensation during the year. The total elective deferrals made on behalf of Participant B for calendar year 2015 was $21,000. The IRC Section 402(g) limit for a person under age 50 for 2014 is $18,000. So, Participant B had an excess deferral of $3,000. The employer must distribute the excess, plus attributable earnings, by April 15, 2016, in order for Participant B to avoid double taxation.
Note: If Participant B were age 51 in 2015 and the plan permitted catch-up contributions, he would not have excess deferrals because the total elective deferral limit for 2015, including catch-ups, is $24,000 ($18,000 + $6,000).
- Determine if the plan sponsor is a member of an affiliated service group or a controlled group of employers. If so, request copies of plans maintained by related employers if any employee can participate in more than one plan.
- Inspect the plan document(s) to determine the maximum elective deferrals participants can defer, including catch-up contributions.
- Inspect payroll and tax reporting records to ensure each participant complies with the IRC Section 402(g) limit in effect for the year.
- Compare Forms W-2 (Box #12 — code "D" for elective deferrals or "AA" for designated Roth contributions) with payroll records and account statements to reconcile the reported deferral amounts and ensure they are accurate.
- Inspect the Forms W-2 of related employers to ensure participants have not exceeded the limit if they participate in more than one plan during the year.
- After testing the 401(k) plan for IRC Sections 402(g) and 401(a)(30) compliance, ensure that any excesses were properly and timely corrected by April 15th of the following calendar year.
- Inspect Forms 1099-R for distributions and cancelled checks to determine when the distributions were actually made.
- Determine if the participant is eligible to defer to multiple 401(k) plans, 403(b) arrangements or other plans that must be aggregated by the participant to determine if his or her deferral limit is exceeded.
- If so, there is a greater chance that a participant deferred above maximum allowable amounts, because contributions in all plans may not have been aggregated for testing.
- Determine if the participant is eligible to make catch-up contributions to any such plans or arrangements.