|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 ($18,500 in 2018, 19,000 in 2019 and $19,500 in 2020) 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 2019-calendar year is the lesser of:
- 100% of the participant’s compensation or
- $19,000 in 2019 ($19,500 in 2020 and $18,500 in 2018
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 2019 and 2018 is the lesser of $6,000 ($6,500 for 2020 and 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earned on excess elective deferrals for the year contributed is includible in the employee’s income in the year it is withdrawn from the IRA.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 ($6,000 in 2019/2020 and if age 50 or over, $7,000. $5,500 in 2018 and if over age 50 $6,500) 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:
When there is a deferral in excess of the IRC Section 402(g) or IRC Section 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 if the failure is significant. 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. Use the Department of Labor’s Online Calculator to determine earnings if it is not feasible to determine actual earnings in the IRA account.
As an alternative, under VCP or Audit CAP, you may use the Retention of Excess Amounts method (see Mistake #4). If you retain an excess amount in the SARSEP plan, a special additional payment of at least 10% of the excess amount will apply in addition to the VCP user fee or Audit CAP sanction. 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.
Employer X maintains a SARSEP. For calendar year 2018, Bill defers $20,000 to the plan. Bill is under age 50, so he is not eligible to make catch-up contributions. Bill has excess deferrals of $1,500 because $18,500 is the maximum amounted permitted for 2018 ($20,000 - $18,500 = $1,500). Employer X didn't discover this mistake until after April 15, 2019. On July 1, 2019, X effected distribution of the excess deferral (plus applicable earnings of $100, totaling $1,600) to Bill.
For 2018 (year of deferral), Bill must include the $1,500 in gross income. For 2019 (year of distribution), Bill must include the $1,600 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:
The example shows an operational problem because the employer failed to follow the terms of the plan by exceeding the limits stated in the plan document and the IRC. Therefore, if Employer I meets the eligibility requirements of SCP, they may be able to use SCP to correct the failure by using the distribution of excess amounts correction method. Employer I would have to determine whether:
- Appropriate practices and procedures were originally in place to facilitate compliance with requirements for maximum contribution limits.
- The failure is insignificant.
Voluntary Correction Program:
Under VCP, correction is the same as described under “Reasonable correction.” Employer X files a VCP submission according to Revenue Procedure 2019-19 via the Pay.gov website following the procedures in Section 11. Employer X uses Form 14568, Model VCP Compliance Statement (PDF), including Form 14568-C, Model VCP Compliance Statement - Schedule 3: SEPs and SARSEPs (PDF) to describe the failures and how they are corrected. Note the retention correction method is not available if you use Form 14568-C. User fees for VCP submissions are generally based upon the current value of all IRAs associated with the SARSEP plan. If Employer X chooses to retain the excess amounts in participants’ IRAs associated with the SARSEP, they must use VCP. If this correction method is used, a special additional payment of at least 10% of the excess amount will apply. This is in addition to the VCP submission user fee. The extra payment is a sanction payment that will be collected as part of a voluntary closing agreement that will be signed by the plan sponsor and the IRS.
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 that is not excessive, considers facts and circumstances, and bears a reasonable relationship to the nature, extent and severity of the failures, based upon all relevant factors described in section 14 of Rev. Proc. 2019-19.
How to avoid the mistake:
Determine the IRC Section 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.