(b)lines Ask the Experts – Correcting Excess Deferrals

Michael A. Webb, Vice President, Retirement Plan Services, Cammack LaRhette Consulting, answers:    

Excellent and timely question, since the precise correction procedure for addressing an excess deferral is often misunderstood, and a key correction deadline is fast approaching. First, the plan vendor should be notified of the amount of the excess deferral. The vendor will then calculate the earnings attributable to the excess and issue a distribution to the participant in the amount of the excess, plus earnings (or less losses, if any). Since the vendor must distribute the excess deferral by April 15, 2011, you should notify the vendor immediately of the excess deferral. No adjustments should be made to the participant’s W-2 (i.e., the entire amount of the deferral, including the excess, should be reflected in Box 12 of the W-2).  

You should also inform the participant immediately of the excess deferral amount as he/she will need to add the amount of the excess deferral so what he/she may include this amount on Line 7 (Wages, salaries, tips, etc.) of his/her 2010 1040 tax return. If the participant has already filed his/her 1040 for 2010, he/she must file an amended return (1040-X) indicating the additional income. Also note that the participant must file a 1040 tax return in 2010: he/she cannot file a 1040A or 1040EZ. Similar rules apply to the participant’s state income tax filing, with the exception of states that do not recognize an income tax exclusion for deferrals in the first place (e.g., NJ, where ALL 403(b) deferrals-but not 401(k) deferrals-are taxable as income).  

As for the income attributable to the excess deferral, such income will be taxable in the year of distribution (2011 in this case). Although the IRS procedures are not specific in this regard, it is presumed that such income would be added to Line 7 of the 2011 1040 return (again, the participant must file a 1040). If a loss (rather than income) is attributed to the excess deferral, it is also reported on the participant’s 1040 for 2011, but there is a special reporting procedure. The loss amount is reported as a negative amount on Line 21 of the 2011 1040 (Other Income) and the type of income must be identified as a “Loss on Excess Deferral Distribution”.   

As for the official reporting of the transaction to the IRS, The vendor will issue two 1099-R reporting forms in early 2012; one for the principal amount of the excess deferral (already declared by the participant as income in 2010) and one for the earnings attributable to the excess deferral (which the participant would report as income, as described above, on his/her 2011 1040 tax return). If a loss is incurred with regard to the excess deferral, only one 1099-R will be issued. 1099-Rs are for IRS reporting purposes only, and are not attached to tax returns.   

If the vendor is unable to distribute the excess deferral by April 15th, 2011, this error is considered to be an operational failure of the plan. Such a failure may be self-corrected under the Self-Correction Program (SCP) of EPCRS, which fortunately does not require a formal submission to the IRS. Such an operational failure may be corrected until the end of the second calendar year following the year the excess deferrals were made (December 31st, 2013, in this case). However, there is a key drawback to not correcting by April 15^th –  the principal amount of the excess is taxed twice; once in the year of deferral (2010) and once in the year of distribution (2011). The earnings are only taxed once, in the year of distribution (2011). In time for the participant’s 2011 tax filing, the vendor will issue two 2011 1099-R forms; one coded with a special code indicating that the amount is taxable in 2010, and another indicating the principal and earnings taxable in 2011.   

Finally, since one can easily see that correcting an excess deferral can impose a significant administrative burden, practices and procedures should be evaluate to make certain that future errors do not occur (Note; this is a REQUIRED step for excess deferrals corrected after April 15th under SCP). In the error of modern payroll systems, excess deferrals have become far less frequent, and the plan’s operating system should be thoroughly evaluated in the wake of this error to confirm  that automated limitations are in place and fully operational.