Many employers have added a Roth feature to their 401(k), 403(b) or governmental 457(b) plans. This feature allows employees to choose to designate some or all of their elective contributions as Roth contributions. Employees must make this designation before the deferral is withheld from their salary. A Roth contribution differs from a pre-tax elective contribution in that the Roth contribution amount is included in gross income.
A common mistake we’ve encountered in the operation of a Roth feature is that the employer doesn’t follow the employee’s election as to the type of elective deferral.
The employee elects a Roth contribution, but the employer treats it as a pre-tax deferral.
Example 1: The ABC Corporation 401(k) Plan includes a Roth feature. In 2013, Marcie elected to defer $5,000 of her salary as a Roth contribution to the plan. In 2014, the plan administrator discovered that Marcie’s contribution was made as a pre-tax deferral and not the Roth contribution that she elected.
Fixing the mistake
To fix the mistake of not following an employee’s election to designate the contribution as a Roth contribution you must transfer the deferrals, adjusted for earnings, from the pre-tax account to the Roth account. There are two options on how to report this transfer:
- The employer issues a corrected Form W-2 and Marcie must file an amended Form 1040 for the year of the failure (2013).
- The employer includes the amount transferred from the pre-tax to the Roth account in Marcie’s compensation in the year it’s transferred (2014). If the employer elects, it may compensate Marcie for the additional amount she owes in income tax in 2014. This must be included in Marcie’s 2014 income.
The employee elects pre-tax deferral, but the employer treats it as a Roth contribution.
Example 2: In 2013, Marco elected to contribute $6,000 to the XYZ Corporation 401(k) Plan, which allows both pre-tax and Roth contributions. Marco elected to make a pre-tax deferral. Despite Marco’s election, the XYZ Corporation realized in 2014 that Marco’s contribution for 2013 was made as a Roth contribution and not the pre-tax deferral that he elected.
Fixing the mistake
The XYZ Corporation can transfer the erroneously deposited deferrals, adjusted for earnings, from the Roth account to the pre-tax account. The XYZ Corporation would file a corrected W-2 and Marco would file an amended 1040 for the year of the failure (2013).
Correction programs available
The plan sponsor can use the Voluntary Correction Program (VCP) (if the error is significant and it meets the other conditions of VC). The error can be self-corrected, without IRS approval, if the mistake is insignificant or, if significant, if the plan sponsor corrects the mistake within two years. A plan sponsor can use self-correction only if the plan has practices and procedures in place designed to promote overall tax law compliance. If the plan is under IRS examination, then mistakes are generally corrected under a closing agreement using the Audit Closing Agreement Program.
Making sure it doesn’t happen again
Establish procedures that ensure that the participants’ elections are correctly implemented. This could include educating those responsible for processing the deferral elections on how to interpret and implement the information on the election forms. In addition, periodically check the process of withholding, classifying and depositing salary deferrals so that you can timely fix errors and adjust internal controls, as needed.