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Oops … How to fix switched contributions

“My client initially elected to make designated Roth contributions to her 401(k) plan and a few years later switched her election to pre-tax elective deferrals. We just discovered the employer is still treating her deferrals as designated Roth contributions. Is there a way to retroactively treat these amounts as pre-tax salary deferrals?”

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with a financial advisor from Massachusetts is representative of a common inquiry related to designated Roth contributions in 401(k) plans.

Highlights of the Discussion

Yes, there is a way of correcting the situation where an employer has failed to make the correct type of salary deferral to a 401(k) plan (i.e., pre-tax/designated Roth, or vice versa) based on the participant’s deferral election. It will require some correcting of IRS tax forms and the employer’s participation in the IRS’s Employee Plans Compliance Resolution System (EPCRS) program. Please refer to Fixing Common Mistakes-Correcting a Roth Contribution Failure and Revenue Procedure 2019-19.  

Generally speaking, an employer in this situation can correct the error by executing three steps.

Step 1: Transfer deferrals

The employer transfers the erroneously deposited deferrals, adjusted for earnings, from the designated Roth account to the pre-tax salary deferral account. The employer must ensure the information on IRS Form W-2, Wage and Tax Statement, for the participant is correct (i.e., reflecting the correct contribution type). That may involve the employer filing a corrected Form W-2 with the IRS showing the previously misidentified designated Roth contributions as pre-tax salary deferrals.

Step 2: Follow EPCRS or Audit CAP

Since the error represents an operational failure on the plan sponsor’s part, the sponsor should follow plan correction procedures outlined in the IRS’s EPCRS program. Depending on the circumstances, it may be possible for the employer to self-correct the error, without penalty or a formal filing with the IRS. Otherwise, a sponsor can file with the IRS under the IRS’s Voluntary Correction Program (VCP). If the error was discovered during an IRS audit, the only corrective option is to follow the Audit Closing Agreement Program (Audit CAP).

Step 3: Establish avoidance procedures

Part of correcting a plan error is to ensure that the error will not happen again. Plan sponsors should create, document and follow new policies and procedures that will prevent future failures such as these.

Conclusion

The IRS has identified the misclassification of employee salary deferrals as designated Roth contributions and vice versa by plan sponsors as a common plan mistake. Fortunately, there is a relatively painless IRS process to remedy the situation.

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Roth 401(k)s and the Five-Year Clock

“Can you explain how the ‘five-year clock’ applies to Roth 401(k) contributions?”

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with a financial advisor from New York is representative of a common inquiry related to designated Roth contributions in a 401(k) plan.

Highlights of the Discussion

Distributions of Roth 401(k) contributions (i.e., designated Roth contributions) can be taken tax and penalty free if the participant meets certain conditions for a “qualifying distribution.” A qualifying distribution is one that is made after a five-taxable-year period of participation (“the five-year clock”), and the participant has attained age 59 ½, has become disabled, or in the case of a beneficiary, following the participant’s death.

The five-year clock begins on the first day of the participant’s taxable year in which he or she first makes designated Roth contributions to the plan. If the first Roth contribution is a rollover of designated Roth contributions from another 401(k) plan, the starting of the five-year clock depends on whether the rollover is direct or indirect.

If the participant completes a direct rollover from a designated Roth account under another 401(k) plan, the five-year period is deemed to have begun on the first day of the taxable year that the employee made Roth 401(k) contributions to the other plan. In contrast, an indirect rollover contribution restarts the five-year clock under the receiving plan for a participant who has made no prior Roth 401(k) contributions to the receiving plan (Treasury Regulation 1.402A-1, Q&A 4).

Conclusion

Since the five-year clock for determining a tax-free, qualifying distribution of Roth 401(k) contributions begins on the first day of the participant’s taxable year in which he or she first makes a designated Roth contribution to the plan, it may be wise for a participant—if he or she has the option—to designate even $1 of elective contributions as a Roth 401(k) contribution right away in order to start the ticking of the five-year clock. And if a participant is rolling over Roth 401(k) contributions—a direct rollover is the only way to avoid restarting the five-year period.

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Federal Withholding on an In-Plan Roth Conversion

“How do the federal withholding rules apply to an in-plan Roth conversion in a 401(k) plan?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

Highlights of Discussion

  • The federal withholding rules for in-plan conversions to a designated Roth account in a 401(k) plan are similar to the rules that generally apply for eligible rollover distributions that are rolled over directly to another eligible plan versus rolled over indirectly (i.e., within 60 days) (Internal Revenue Code Section 3405). The IRS has provided specific guidance for in-plan Roth conversions in Notice 2013-74 Q&A 4.
  • If the conversion of assets in-plan is done as a direct rollover to the designated Roth account, and the participant does not receive any of the assets, the plan sponsor should not withhold taxes. Neither can a participant request voluntary withholding under IRC Sec. 3402(p). Since a conversion is generally a taxable event, a plan participant making a direct in-plan Roth conversion may need to increase his or her withholding or make estimated tax payments to avoid an underpayment penalty from the IRS.
  • In contrast, if a plan participant receives a distribution in cash from the plan, the plan sponsor must withhold 20 percent federal income tax even if the participant later rolls over the distribution to a designated Roth account within 60 days. Because plan sponsors do not apply federal income tax withholding to a direct in-plan Roth conversion, a plan participant may need to increase his or her withholding or make estimated tax payments to avoid an underpayment penalty from the IRS.

Conclusion

Because plan sponsors do not apply federal income tax withholding to a direct in-plan Roth conversion, a plan participant may need to increase his or her withholding or make estimated tax payments to avoid an underpayment penalty from the IRS.

 

 

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