Properly Correcting 402(g) Excess Deferrals

“I am trying to find out about how to properly correct 2021 402(g) excess deferrals made to our 403(b) plan, but it appears that the Experts have not written on that subject in quite some time. Can you provide updated information in this regard?”

Charles Filips, Kimberly Boberg, David Levine and David Powell, with Groom Law Group, and Michael A. Webb, senior financial adviser at CAPTRUST, answer:

Indeed, the Experts have not written on this subject since 2018, primarily because advances in payroll technology have greatly reduced these types of excesses. However, likely due to increased savings rates as a result of the pandemic, the Experts have fielded a number of 402(g) excess deferral questions in 2022. Thus, it is certainly time for a refresher!

For those who might not be aware of a 402(g) excess deferral, it is occurs when an employee’s total elective deferrals exceed the annual limit for retirement plans in a calendar year. For 2021, that limit was $19,500 ($26,000 if the participant was age 50 or older as of 12/31/2021). (There are some additional expansions of the limit for certain 403(b) and 457(b) plan participants, but these are the limits for most employees.) For example, if a participant older than 50 deferred $30,000 in 2021, he/she would have an excess deferral of $4,000 ($30,000-$26,000).

As for correcting a 402(g) excess deferral, first, the plan’s recordkeeper should be notified of the amount of the excess deferral. The recordkeeper 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). For 2021, since the recordkeeper must distribute the excess deferral (and any earnings accrued) by no later than April 18, 2022 (i.e., the individual’s tax deadline in the year following the year of deferral), you should notify the recordkeeper immediately of the excess deferral. It is important that NO adjustments 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 to Line 1 (Wages, salaries, tips, etc.) of his/her 2021 1040 or 1040-SR tax return. Similar rules apply to the participant’s state income tax filing, except for states that do not recognize an income tax exclusion for deferrals in the first place (e.g., New Jersey, where ALL 403(b) deferrals—but not 401(k) deferrals—are taxable as income).

The income attributable to the excess deferral will be taxable in the year of distribution (2022 in this case). This income would be added to Line 1 of the 2022 1040/1040-SR return. If a loss (rather than income) is attributed to the excess deferral, it is also reported on the participant’s 1040/1040-SR for 2022, but there is a special reporting procedure. The loss amount is reported as a negative amount on Line 8z of Schedule 1 of the 2022 1040/1040-SR (Other Income) and the type of income must be identified as a “Loss on Excess Deferral Distribution.” You should note that if the distribution occurs after April 18, 2022, the excess deferral is taxable in the year of the deferral and the year distributed. The earnings are taxable only in the year distributed. As such, it is important to make timely distributions.

As for the official reporting of the transaction to the IRS, the plan must report corrective distributions of excess deferrals (including earnings) on Form 1099-R. For excess deferrals and earnings distributed between January 1 and April 18, 2022, the recordkeeper will generally issue two 1099-R reporting forms in early 2023; one for the principal amount of the excess deferral (already declared by the participant as income in 2021) and one for the earnings attributable to the excess deferral (which the participant would report as income, as described above, on his/her 2022 1040/1040-SR tax return). However, 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. Notably, the excess deferrals and income are not eligible for rollover.

NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.

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