401K Excess Contribution Question

Submitted by Andrew Richmond on Wed, 2021-01-27 15:18

I received a call last year from an attorney that represents a company I worked for up until 2017. When I left the company, they contributed a $20K bonus into my 401K as part of my severance package. During a recent audit in 2020 they determined that the plan does not allow them to provide a bonus into the 401K unless I’m employed there on the final calendar day of the year (which I was not).

My own contributions to the 401K were under the $18K limit, and the total contributions including employer match and bonus were under the $54K limit that was in place in 2017. So as far as I can tell I did not violate any IRS regulation regarding contributions.

Their issue is that they violated their own plan rules. They requested to claw the money back from my 401K account and reissue it to me as payroll. However, I had already rolled over the money to a personal IRA, so the money was no longer accessible to them.

This week I received a 1099-R form showing a gross distribution of approximately $21K that was deemed taxable. It appears they attempted to reclassify the income as taxable income under Distribution Code E – Employee Plans Compliance Resolution System.

I spoke with a tax attorney who told me that I could accept the 1099-R and pay the federal and state taxes on the income but leave the money in my IRA and add it to my cost basis for non-deductible contributions. However, since the annual limit for contributions is $7,000 I’m not clear on how this would work. If I were to file an 8606 form showing a $21K IRA contribution would it raise a red flag with the IRS? Or should Fidelity (the custodian of the 401K and now my individual IRA) have distributed the $21K in conjunction with sending me the 1099-R?



Submitted by Alan - IRA critic on Wed, 2021-01-27 17:09

This is called a plan overpayment and these obviously have very ugly implications. The first one is the 1099R which tells you and the IRS that 21,000 of the amount you rolled over was an excess plan contribution and therefore not eligible for rollover. It does not matter whose fault this was. Some DB plans even attempt to claw back DB pension payments made for decades if they find a calculation error (or the DOL does in an audit).
Since your 401k and IRA are different plans, even though FIdelity might be told of the excess IRA contribution, they have no authority to just distribute it since you have the right to apply it as later year IRA contributions you might have been eligible for but not made, or you might also have taken an IRA distribution in the meantime that would have offset the IRA excess. Both of these are done on Form 5329 by simply following the 5329 instructions. In theory you also have the option of paying the IRA excess contribution excise tax or 6% each year, although that is very costly and only beneficial in some cases in the first second year to protect the earnings on the IRA excess. You are past that now, and to correct the excess IRA contribution you only need to request a normal distribution of 21,000 with no mention of an excess and any earnings remain in the IRA. This distribution is reported on Form 1040 and Form 5329 as mentioned above. Otherwise, you owe the 6% excise tax for 2017-2020 (4 years) and there is no IRS Statute of Limitations on excess IRA contributions. Attempting to treat the 21000 as a non deductible IRA contribution is not valid (it would still be excess and exceed the contribution limit), so forget that idea. If you decide to leave the excess in the IRA that would be playing the audit lottery and the E coded 1099R will be a large red flag to the IRS.
The other big issue is the actual clawback. Some plans are aggressive and other plans may not pursue collection.  No telling how aggressive your plan might be. Many in your shoes hold out on repayment and the plan may back off. Some participants have been known to offer repayment less the amount these additional taxes and penalty have cost them due to the plan error. 
Nothing you can do about the 2020 1099R as it is not incorrect.  It treats the 21,000 as distributed from the plan along with the eligible rollover funds. The code E will be treated by tax software as taxable income for the year of the 1099R, which I assume is 2020. You will not have to amend prior returns. On your 2020 return I am not sure whether the 21000 will be added to the wages line or the pension distribution line 5. Even if you are under 59.5, there is no 10% penalty on an E coded corrective distribution.
Now lets assume that you DO eventually repay the 21000 to the plan. In order to address the taxes you paid on income that was clawed back, you should qualify for a “Claim of RIght” deduction or credit per Sec 1341.  Applicable IRS Reg added below:
21.6.6 Specific Claims and Other Issues | Internal Revenue Service (irs.gov)

Submitted by David Mertz on Wed, 2021-01-27 17:59

As Alan implied in the second bullet, if you did not make the maximum IRA contribution that you were permitted to make for the years that the excess was present in the traditional IRA, you could apply a portion of the $21,000 as a regular traditional IRA contribution for each of those years to reduce the amount of excess that was subject to an excess-contribution penalty and carried forward to subsequent years.  It’s not clear how much might be able to be treated in this way because it’s not clear exactly when the rollover deposit was made to the traditional IRA.  Whatever amount can be treated as part of your regular traditional IRA contribution for a particular year can be treated as nondeductible and add to your basis in nondeductible traditional IRA contributions.

Submitted by Andrew Richmond on Wed, 2021-01-27 22:26

Thanks for the excellent feedback!  I retired in 2017 and have no earned income in any subsequent years so I don’t believe I can contribute any of the $21,000 for years after 2017. If I’m understanding this correctly, it sounds like the best way to resolve this is to request that Fidelity issue a distribution of $21K from my IRA to match the 1099-R.  Is there any issue with the fact that the distribution takes place in 2021 but the 1099-R is dated 2020? I’ve filled out the information in Turbotax and it indicates that no penalties apply, presumably because of the distribution code E? Also, the company has not requested a clawback now that the funds have been removed from the account so I’m not expecting any further action from the company beyond the 1099-R.

Submitted by Alan - IRA critic on Wed, 2021-01-27 22:55

You are correct that you cannot absorb the TIRA excess without any earned income. The 21k 1099R will be a 2020 taxable distribution, but there is no early withdrawal penalty on any E coded distribution. The corrective IRA distribution you take can be done anytime to stop the annual 6% excise taxes from adding more years. You incur a new 6% penalty every 1/1 if the excess is still in the account at year end. Because you will not get hit with another excise tax until 1/1/2022, you could leave the excess in the IRA until December before taking the distribution in the hope that more tax deferred gains will be generated on that 21000 throughout 2021. You will have to file a 5329 for each year through 2021. 2017-2020 to pay the excise tax and 2021 to show the distribution that cures the excess. There will be no excise tax due for 2021. Since these 6% penalties will be paid late since you will be filing the older 5329 forms now, the IRS could bill you late interest on payment of the 2017-2019 excise taxes. The 2020 5329 can be filed with your 2020 return, the older ones can be filed alone since they are considered tax returns. Start with 2017 because 5329 forms are cumulative, bringing forward excess amounts that are still in the IRA at the end of each year.

Submitted by Andrew Richmond on Thu, 2021-01-28 00:24

Given that this was the employer’s mistake, is it reasonable for me to expect them to make me whole such that I’m not worse off than if they had not deposited the $21K in my 401K in the first place?

Submitted by Alan - IRA critic on Thu, 2021-01-28 04:19

It might be reasonable but they probably are not inclined to do so, nor legally required to do so.

Submitted by Andrew Richmond on Thu, 2021-01-28 15:59

I’m not an expert at reading and understanding IRS publications, but looking at the IRS published steps for self correction, doesn’t #2 suggest they have to make me whole financially with regards to their error?    There is no fee for self-correction of retirement plan errors. Nothing needs to be filed with the IRS. However, the plan sponsor should maintain adequate records to demonstrate correction in the event of a plan audit.Steps to self-correct
Make sure that you’re eligible to self-correct. Is the failure eligible for self-correction, and did your plan have appropriate practices and procedures?
Make any necessary corrections to put the participants in the position they would have been in if the error had not occurred.
Document the steps you took to correct the error.
Adjust your administrative procedures, if necessary, to make sure the mistake does not happen again.
https://www.irs.gov/retirement-plans/steps-to-self-correct-retirement-plan-errors

Submitted by Alan - IRA critic on Thu, 2021-01-28 17:16

The problem here is that the notification you received IS a self correction of a plan error, but since the error was in your favor, the correction was not.
Point 2 is referring mainly to participants who were short changed by the plan error, eg a contribution they should have received but didn’t must be made to make up the shortfall. 
EPCRS provides a number of options for a plan to defray the negative effects of certain rules. For example, an excess deferral that would ordinarily be returned with earnings can instead be recharacterized as an after tax contribution. 
I don’t know if there is an approved procedure that the plan could take if it was part of the plan document OR was part of the plan operating procedures that were not included in the plan document, to restore this contribution, but since a plan cannot be discriminatory if they were able to restore your contribution, they would also have to restore the contributions for all other participants that fell victim to the plan error. It is not clear whether the plan could have done so and overlooked their operating procedures in your case or the notice you received was their only option. In other words, even if they could have allowed the error to go uncorrected, they would have to do so for everyone else. In that vein, you might ask them if they have ever let this particular procedural error pass for any other participant or if there is any option to back off.  And even if they did and told you that you did not have to return the excess, that may not necessarily resolve the IRA excess contribution. They would also have to issue a corrected 1099R to 0 out the one you received to do that. 
See p 72 of the following from noted expert in this area, Natalie Choate, although I wish she had gone deeper into the claim of right deduction situation:
IRAMistakes2018-2.pdf (jointtaxandestate.com)

Submitted by Andrew Richmond on Fri, 2021-01-29 16:25

Thank you so much for the great advice Alan!  I really appreciate it.One thought I had to minimize the penalties – in 2017 I contributed $17,600 to my 401K.  Being over 50 I was eligible to contribute up to $24,000.  Can I recharacterize some of the excess bonus contribution as my own personal contribution to get me to the fully allowable $24,000?

Submitted by Alan - IRA critic on Fri, 2021-01-29 19:01

No, the participant can never recharacterize 401k contributions. In some cases the plan can do it with your contributions, but your contributions are not the issue here. The plan itself made a disallowed profit sharing or matching contribution that violated the plan document and there is no way to replace that contribution unless their audit detected some error where they did not contribute when the plan required them to.

Submitted by Andrew Richmond on Fri, 2021-01-29 19:19

Ok, that makes sense, thank you! So moving forward two things are still confusing me: 1) How to I address the fact that the 1099-R is for 2020 but if I request that Fidelity distribute the $21K it will be a 2021 transaction?  I’m concerned that it will look like I took a withdrawal in both 2020 and 2021. 2) Am I required to file 5329 forms through 2020 or 2021 given that I still have not taken the distribution?

Submitted by Alan - IRA critic on Fri, 2021-01-29 23:07

Good point. In a prior post I indicated that the 21000 must be distributed from the IRA, but did not go into the actual somewhat confusing mechanics that will avoid double taxation for you. As you know, you will be taxed on the 1099R you already received for 2020, so you should NOT be taxed on the distribution of the excess amount from the IRA of 21000.
Pub 590A under Excess contributions removed after the due, there is a paragraph describing “Excess due to incorrect rollover information”.  Your IRA excess was created by that 2017 1099R coded E. But you do not have to amend 2017 because the 21000 of taxable income will be reported in 2020.
Therefore, you must carefully request the 21000 IRA distribution, stating that it being requested under Sec 408(d)(5). Per the 1099R Inst for box 2a, this should produce a 1099R from the IRA with Box 2a blank (no taxable income), and the “taxable amount not determined” box checked in 2b.
Nonetheless, even if you secure the desired 1099R, you should include an explanatory statement with your 2021 return indicating why no tax is due. Indicate that a plan excess was rolled over in 2017, and the plan issued an E coded 1099R in 2020 requiring you to report taxable income of 21000. You are then removing the 21000 excess from the IRA due to incorrect rollover information.
If you still get a 1099R with a taxable amount, try to get it corrected. If they refuse, then you should still report 0 and provide a more detailed explanation to the IRS than the one above.  So you ARE getting two 1099R forms (two plans) for essentially the same 21000, but only the one you already have should be taxable.
You will need a 5329 to pay the IRA 6% excise tax for 2017-2020.  You will also need one with your 2021 return showing the 21000 distribution discussed above, and the form subtracts that distribution from your excess coming into 2021, erasing the excess. No excise tax will be due for 2021. You WILL have to report the IRA 1099R in 2021, but no taxable income on line 4b of Form 1040.

Submitted by Andrew Richmond on Wed, 2021-02-03 15:18

Thanks again for the excellent feedback Alan.  Needed a couple of days to think through all of this.  I took another look at the paragraph in the plan that caused the audit.  Here it is:    
5. Discretionary Nonelective Contributions 
Your Employer may make discretionary nonelective contributions in an amount to be determined by the Board of Directors for each Plan Year. You must complete at least 1,000 hours of service during the Plan Year and be employed as of the last day of the Plan Year to be eligible to receive any nonelective contributions that may be made for that Plan Year. You do not need to satisfy this requirement if you die (including death while performing Qualified Military Service), become disabled or retire during the Plan Year. 
The plan has an exception to the “employed on the last day of the year” requirement if I retire during the plan year.  I did retire that year and have not worked since.  Can I take the position that the company erred in doing the correction because it was a legitimate contribution due to me retiring during the plan year?  If I did this, should I still withdraw the money from the IRA to match the 1099-R but just argue that it should not be subject to penalty or should I not withdraw the money at all?

Submitted by Alan - IRA critic on Wed, 2021-02-03 18:51

This appears to be a profit sharing contribution being clawed back. PS contributions are different than matching contributions, and matching contributions are not the same as non elective contributions. But it is worth appealing since the plan appears to be describing the PS contribution as nonelective and of course discretionary. Perhaps they overlooked this exception.
If they agree that they are in violation of their own provisions, they need to correct the 1099R to 0. That removes the taxable distribution as well as the IRA excess contribution, and also the request for clawback. Would appeal ASAP since the longer this goes unchanged, the greater the hassle for both the plan and yourself to unwind it.

Submitted by Andrew Richmond on Wed, 2021-02-03 23:57

Understood.  If I can’t get them to respond (so far they have not returned any of my calls), can I just write a letter to the IRS and submit a copy of the plan along with an explanation of why I disagree with the 1099-R?

Submitted by Alan - IRA critic on Thu, 2021-02-04 01:26

You could, but the IRS wants these types of questions resolved at the source (the plan).  The odds are not in your favor by appealing this to the IRS. You could improve those odds by hiring an enrolled agent (EA) to present your case, but that would of course be very costly. Alternatively, you could resist repayment as far a practicable, and if you are forced to repay, then you could look into  the claim of right deduction or credit. The deduction is a misc deduction not subject to the 2% AGI floor, so a credit would likely be preferable.

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