SunGard Relius

It is an annual ritual that during the first few months of each new calendar year, 401(k) plan administrators calculate and complete corrective distributions for failed ADP and ACP tests for the prior plan year (typically the calendar year), and excess deferrals for the prior calendar year. That process necessitates a review of the rules governing these corrective distributions. The purpose of this technical update is to review the rules, including recent law changes, relating to 401(k) plan corrective distributions.

What are the taxation and reporting rules regarding a distribution of excess contributions or excess aggregate contributions?

As a result of PPA, a distribution of excess contributions or excess aggregate contributions (to correct an ADP or ACP test failure) is treated for tax purposes as received in the year of distribution, even if the distribution occurs within 2½ months after the close of the 2008 plan year. See Code §4979(f)(2), adopted by PPA §902(e), and effective for plan years beginning after December 31, 2007. This means that the distribution is taxable in the year of distribution (unless the distribution includes Roth deferrals that were contributed on an after-tax basis). The corrective distribution must include allocable earnings. The earnings on the corrective distribution (whether pre-tax or Roth deferrals) also are taxable in the year of distribution. The plan administrator documents the distribution by issuing a Form 1099-R (a 2009 form for a distribution during 2009) showing the total amount of the distribution in box 1, the taxable amount of the distribution in box 2a, and code 8 in box 7 (indicating current year taxation). The distribution amount and the taxable amount will be the same (unless the distribution includes Roth deferrals). The corrective distribution is not an eligible rollover distribution. At the time of the distribution plan administrators should advise the participant of the year in which the distribution is taxable.

Example 1: Plan X is a calendar year 401(k) plan that fails the ADP test for 2008. On March 1, 2009, the plan makes a corrective distribution to Jeff in the amount of $1,000, plus $20 allocable income. The entire $1,020 distribution will be taxable in 2009, the year of the distribution. The plan must issue a 2009 Form 1099-R showing $1,020 in box 1 and in box 2a.

Example 2: Assume the same facts, except Jeff made Roth deferrals to the plan. In this case, the $1,000 of deferrals were included in Jeff’s income in 2008, the year of the deferrals. The plan’s 2009 Form 1099-R on the corrective distribution will show $1,020 in box 1, but only $20 as the taxable amount in box 2a.

Example 3: Assume the same facts as in Example 1, except a net loss of $100 is attributable to the $1,000 corrective distribution amount. The plan distributes the net corrective distribution of $900. The plan must issue a 2009 Form 1099-R showing $900 in box 1 and in box 2a.

Example 4: Assume the facts of the previous example (net loss of $100), but assume, as in example 2, the deferrals were Roth deferrals. Again, the plan distributes the net corrective distribution of $900. The plan issues a 2009 Form 1099-R showing $900 in box 1, and $0 taxable amount in box 2a.

In each example, the Form shows code 8 in box 7. Note that if the distribution occurs more than 2½ months after the close of the plan year (or 6 months in the case of a EACA), the tax consequences to the participant are the same, but the employer will be liable for a 10% penalty tax on the corrective distribution amount. See Code §4979.

Must a 2009 distribution of excess contributions or excess aggregate contributions include gap period earnings (i.e., earnings from the end of the plan year to the date of distribution)?

No. For post-2007 plan years, the plan calculates allocable earnings only through the end of the plan year on ADP and ACP corrective distributions. Prop. Treas. Reg. §1.401(k)-2(b)(2)(iv). See Code §4979(f)(2), as amended by PPA. Since the plan calculates allocable earnings only through the end of the plan year, the plan should not take into account earnings or losses during the gap period, even though a loss during the gap period would have the effect of reducing the corrective distribution. A gap period adjustment no longer is permissible.

What are the withholding requirements regarding a distribution of excess contributions or excess aggregate contributions?

A corrective distribution of excess contributions or excess aggregate contributions is a “nonperiodic” distribution. Nonperiodic distributions generally are subject to 10% withholding, but the recipient may elect out of the withholding. See Code §3405(b). Under prior IRS guidance, if a 401(k) plan makes a corrective distribution of excess contributions or of excess aggregate contributions within 2½ months after the close of the plan year, no federal income tax withholding applies to the distribution. If the distribution occurs more than 2½ months after the close of the plan year, 10% withholding applies to the distribution, and the participant may elect out of withholding on the distribution. See Notice 87-77 and the instructions to 2008 Form 1099-R. The instructions to the 2009 Form 1099-R delete the statement that no withholding applies to a corrective distribution during the 2½ month period, but do not specifically state withholding is required on these corrective distributions, and continue to reference Notice 87-77. The IRS originally may have instituted the “no withholding” rule because at the time of the guidance a corrective distribution by the 2½ month date was taxable in an earlier taxable year, and the employer already would have “closed the books” on the amount of the prior year’s withholding. Although as a result of PPA the corrective distribution is taxable in the year of distribution rather than the year of deferral, the 2009 Form 1099-R instructions are not clear on this issue. Of course, the “no withholding” rule facilitates more efficient plan administration during the short 2½ month period. If the plan is a EACA, a 6 month period applies instead of a 2½ month period. Since the IRS has dropped the “no withholding” language, and may take the position that, notwithstanding the guidance of Notice 87-77, corrective distributions of excess contributions and excess aggregate contributions are subject to 10% withholding by reason of Code §3405, a cautious employer may wish to apply the 10% withholding rule of Code Sec. 3405(b) for these corrective distributions, rather than applying the "no withholding" rule of Notice 87-77. Since a participant subject to 10% withholding may elect out of the withholding, an employer totally avoids the withholding issue by having affected highly compensated employees sign Form W-4P requesting no withholding.

What are the taxation and reporting rules regarding a distribution of excess deferrals?

A plan must distribute excess deferrals (that exceed the 402(g) limit) and allocable earnings by the April 15 of the calendar year following the calendar year of the excess deferrals. However, the plan may distribute excess deferrals any time after the excess arises, including during the calendar year of the excess deferral. The excess deferrals always are taxable in the calendar year of the excess. Allocable income is taxable in the calendar year of distribution. Corrective distributions of excess deferrals are not subject to federal income tax withholding.

For a 2008 pre-tax excess deferral distributed in 2009, the plan administrator will issue a 2009 1099-R showing the amount of the excess deferrals in box 1 and code P in box 7. The taxable amount in box 2a will be the same, unless the participant made Roth deferrals. (In the case of Roth deferrals, the deferrals are taxable as wages in the year of the deferral, and the employer reflects this on the participant’s Form W-2. Therefore, the taxable amount of the Roth deferrals will be zero.) The corrective distribution is not an eligible rollover distribution. The plan administrator will issue a separate 2009 1099-R for a positive earnings amount, showing the earnings distribution amount in box 1 and code 8 in box 7. (If the plan distributes the excess deferrals and allocable income in the year of the excess deferral, only a single Form 1099-R is necessary, since the total distribution will be taxable in the same calendar year.) The plan administrator must advise the participant at the time of distribution of the year in which the distribution is taxable, and that a pre-tax deferral includible in income in the prior year will require the participant to file an amended income tax return if the participant already has filed his/her income tax return for that year.

If there is a loss on the excess deferrals distributed in 2009, the plan administrator will issue a single 1099-R for the actual amount of the distribution (net of the loss), and will advise the participant to include the entire excess deferral amount in income for 2008, and to take a loss on the participant’s 2009 income tax return. The participant reports the loss as a negative amount on line 21 (“Other income”), identifying the loss amount as a “Loss on Excess Deferral Distribution.” See IRS Publication 525. If distributed by the following April 15, no withholding applies to the distribution of the allocable income on the excess deferrals.

Example 5: Assume Betty has pre-tax excess deferrals for 2008 of $1,000. Because of plan investment losses, a loss of $50 is attributable to the excess deferrals. The plan distributes $950 to Betty on April 1, 2009. The plan issues a single 2009 Form 1099-R to Betty showing $950 in box 1 and in box 2a. However, the plan administrator must advise Betty to include the total $1,000 excess deferral amount in her 2008 gross income, and to take a loss of $50 on her 2009 income tax return.

Must a 2009 distribution of excess deferrals include gap period earnings (i.e., earnings from the end of the plan year to the date of distribution)?

No. WRERA 2008 amended Code §402(g)(2)(A)(ii) to provide for a corrective distribution of allocable earnings on excess deferrals only through the end of the taxable year of the excess deferrals. WRERA provides that the amendment is effective as if included in the PPA provisions to which the amendment relates. See WRERA §112. Therefore, the elimination of the gap period income requirement applies to 2008 excess deferrals distributed in 2009.

SunGard will present a Web Seminar, Making and Taxing Corrective Distributions after PPA.
This year is like no other as we simultaneously (1) transition to the new PPA rules on ADP and ACP corrections; (2) address WRERA changes to gap period income; (3) deal with the effects a slowing economy has on ADP and ACP tests; and (4) deal with the effects of serious losses affecting corrective distributions. Don’t miss it! Thursday, March 5, 2:00-3:40 p.m. ET