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Fixing Common Plan Mistakes - Excess Deferrals

The Issue

Many of you have a 401(k) plan which allows for elective deferrals. The law - the Internal Revenue Code - imposes a limit on the maximum elective deferrals that an employee can make each year to a qualified plan. This includes elective deferrals under 401(k) arrangements (including SIMPLE 401(k) and safe harbor 401(k) plans), 403(b) plans and SIMPLE IRAs. Making deferrals in excess of legal limits is one of the top 10 issues identified during examinations of 401(k) plans.

The Problem

The elective deferral limit is a flat dollar amount that is subject to annual cost-of-living adjustments. The limit for traditional or safe-harbor 401(k) plans in 2006 was $15,000 and is $15,500 in 2007 with increased limits for participants age 50 or more (an additional $5,000 in 2006 and 2007 - known as “catch-up” contributions). Employees whose elective deferrals exceed the limit must report the excess as income on their tax returns for the calendar year the deferral was made and on their tax returns for the calendar year when the excess amounts are withdrawn. If elective deferrals, all from the same employer, exceed the limit, the plan is disqualified. The only way to correct the mistake, avoid double taxation and potential plan disqualification is to have the excess amount, plus earnings, refunded to the employee by the tax-filing deadline for the year in which the deferrals were made (for example, by April 15, 2007 for excess deferrals made during calendar-year 2006). In that case, the excess deferral need only be reported as taxable income for the year the deferral was made. Refunded earnings attributable to an excess deferral must also be reported as income; losses attributable to an excess deferral can reduce reported income in the refund year.

The deferral limit is applied on an aggregate basis to elective deferrals made under all plans maintained by an employer. The employer is responsible for determining whether a participant has excess deferrals under all the retirement plans it maintains. However, excess deferrals by a participant will not disqualify a plan if the excess is due to the aggregation of the participant’s deferrals to a plan maintained by an unrelated employer. We also note that the entire plan, not just the section 401(k) arrangement, is disqualified for violation of the deferral limitation.

Common causes for elective deferral failures include the failure to monitor:

  • limitations for each employee,
  • limitations based on the calendar year, and
  • employees who transfer between divisions/plans of the same employer.

In some cases the employer is not aware that the deferral limitations apply to the participant, rather than the plan. Sometimes, the plan year is other than the calendar year and deferrals are made based on plan year compensation. When testing for compliance, the administrator bases the limitation on the plan year deferrals, rather than deferrals made during the calendar year as required by the law. Violations also occur when the employer and/or plan administrator fail to monitor employees who transfer between divisions and plans of the same employer and allow participants to defer the maximum amount under each plan.

The Fix

As we said earlier, violation of the elective deferral limitation by the plan will cause a plan to become disqualified, resulting in adverse tax consequences to the employer and employees under the plan. Employers may get relief from these adverse consequences through the Employee Plans Compliance Resolution System (EPCRS) by correcting the failures. The Self-Correction Program (SCP) or Voluntary Correction Program (VCP) can be used to correct these mistakes. In order to fix the mistake under SCP, generally the mistake must be fixed within 2 years after the end of the plan year is which the failure occurred. Unless the failure can be classified as insignificant, VCP must be used after this time.

Under EPCRS, the plan may avoid disqualification, even though the plan has failed to correct excess deferrals by the April 15 deadline. The permitted correction method is distributing the excess deferral to the employee and reporting the amount as taxable income in the year of deferral and in the year distributed. Thus, if the corrective distribution is made later than the April 15 deadline, the employee will be subject to double taxation on the excess deferral.  EPCRS does not provide relief from this double taxation.

Making Sure It Doesn’t Happen Again

Employers need to ensure that they have a system in place to monitor salary deferrals for those employees who participate in more than one plan of the employer. Employers should work with plan administrators to ensure that the administrators have sufficient payroll information to verify the deferral limitations were satisfied. Employers may wish to remind plan participants that monitoring deferrals from multiple employers is the participant’s responsibility.

However, keep in mind that, despite all of your good efforts, mistakes can happen. In that case, the IRS can help you correct the problem and retain the benefits of your qualified 401(k) retirement plan.

Page Last Reviewed or Updated: 09-Jan-2017