Exceeding the annual deferral limit comes with significant tax penalties to the individual if the excess is not timely distributed. Because the annual deferral limit is always based on the calendar year, regardless of the 12-month plan year of the retirement plan, the refund deadline for excess deferrals is always April 15th of the calendar year following the year of the deferral*. If excess deferrals are not refunded to the individual tax payor by the deadline, the individual is subject to double taxation (taxed in the year of the excess deferral and taxed in the year of distribution).
With such a harsh penalty, one would think that excess deferrals would be rare, but that does not seem to be the case. In fact, some savvy participants who change jobs mid-year purposely exceed the limit so that they can take advantage of a more generous matching contribution in the new employer’s plan.
*If the tax filing deadline is extended to the next business day because April 15th falls on a weekend or holiday, the deadline to distribute excess deferrals is NOT also extended to the next business day.
How Do Excess Deferrals Occur?
There are two ways that excess deferrals can occur – in more than one plan of unrelated employers (impacts only the individual) or in a single employer’s plan (impacts the individual and the plan’s qualification). There is a big distinction between these two and it will dictate if the excess can be distributed after the April 15th deadline or not. First, let’s review how excess deferrals can happen.
The most common occurrence is when an individual changes jobs mid-year. Obviously, the new employer has no knowledge of the deferrals the employee made to the prior employer’s plan. Many 401(k) plans now offer immediate eligibility, so that newly hired employee is eligible to begin making deferrals to the new employer’s plan on the first paycheck. Unless the employee limits the amount deferred for the remainder of the calendar year, that employee may very well exceed the limit ($20,500 for 2022, plus an additional $6,500 in age 50+ catch-up contributions).
Many recordkeepers permit percentage deferral elections only, so the dollar amount of deferrals for the remainder of the year may be difficult for the employee to predetermine. If the limit is exceeded, the employee may request either the former employer’s plan to distribute the excess or the current employer’s plan may distribute the excess. If the excess is not distributed by April 15th of the following tax year, only the individual is negatively impacted (double taxation—excess deferrals are taxable in the year of the deferral and the subsequent year of distribution). There is no qualification issue for the plan in this situation because the employer did not permit the employee to exceed the limit within the employer’s plan (or plans).
Employees can exceed the deferral limit even without a job change. Most payroll providers have the annual deferral limits coded into the payroll system to prevent an employee from exceeding the annual limit. If the employer uses the same payroll system for the entire calendar year, deferrals should automatically cease once the limit is reached. However, payroll systems are not infallible and there may be unforeseen problems if the system or provider is changed mid-year.
Similarly, employers within a controlled group of related employers may use different payroll systems, but some employees may work for two or more of the entities within the group. If the payroll systems of the related employers are not integrated, excess deferrals may arise. The plan sponsors are responsible for monitoring and preventing employee deferrals from exceeding the annual limit, which can be tricky if related employers operate completely independently of one another.
Regardless how the excess deferrals occur, if they occur under a single employer, both the individual and the employer’s plan will be impacted.
Note: A “single employer” includes all employers that are members of a §414 controlled group of related employers. If members of a controlled group sponsor separate retirement plans, the deferral limit must be monitored for individuals who may perform services for more than one employer in the group and are eligible under one or more of the retirement plans. Oddly enough, this does not apply if the related employers are in an affiliated service group. See our article on related employers for more information.
How Do Excess Deferrals Through a Single Employer Impact Plan Qualification?
If the §402(g) limit is exceeded in a single employer’s plan (or plans) and is not corrected by April 15th of the calendar year following the year of the deferrals, the plan has an operational failure and may be disqualified if uncorrected. Internal Revenue Code §401(a)(30) specifically disqualifies a plan’s trust which does not limit elective deferrals with respect to any individual covered by the plan and all other plans sponsored by the employer (or related employers in a controlled group). For a 403(b) plan, that would include other contracts and arrangements that are specific to that type of retirement plan.
Excess deferral failures, which are in contravention of IRC §401(a)(30), may be corrected under the Employee Plans Compliance Resolution System (EPCRS) if the excess was not timely distributed. The correction for excess deferrals made to a single employer’s plan(s) that were not timely distributed by April 15th is to distribute the excess deferrals from the trust (including earnings).
It is critically important to note that EPCRS only applies when the excess deferrals occur in a single employer’s plan. There must be a §402(g) limit failure by an individual AND it must occur in a single employer plan in contravention of §401(a)(30) for the excess to be distributed after April 15th.
Note: Elective deferrals under a 457(b) plan are not included in the individual §402(g) limit, as deferrals to a 457(b) plan have separate limitations.
Why Are the Correction Methods for Excess Deferrals Often Confused?
Excess deferrals under §402(g) always impact an individual tax payor; however, only excess deferrals that occur in a single employer’s plan that are in contravention of §401(a)(30) causing a plan disqualification failure may be corrected after the April 15th deadline. Let’s review a few examples to clarify the difference.
Example #1 (Two Unrelated Employers): Sally, who is under age 50, worked for Company A and participated in Company A’s 401(k) Plan from January 1, 2022 to August 31, 2022 and made deferrals of $16,000 in 2022 before terminating employment with Company A. On September 1, 2022, Sally was hired by Company Z and became immediately eligible for Company Z’s 401(k) plan. Company A and Company Z are unrelated employers (i.e., not members of a controlled group). Between September 1, 2022 and December 31, 2022, Sally made deferrals to Company Z’s 401(k) plan totaling $8,000. Sally’s deferrals for 2022 are $24,000, which exceeds the §402(g) limit of $20,500 by $3,500. The excess deferrals of $3,500 (including earnings adjustment) may be distributed by either plan, at the request of Sally, if the excess deferrals are distributed before April 15, 2023.
What happens if the excess is not distributed from either Company A’s 401(k) plan or Company Z’s 401(k) plan by April 15, 2023? Company A’s 401(k) plan did not allow Sally to defer more than $20,500 and Company Z’s 401(k) plan did not allow Sally to defer more than $20,500; therefore, neither 401(k) plan has a qualification failure.
Plan documents often provide that individuals who discover they have excess deferrals must request the excess be distributed no later than March 1st of the year following the year of the deferral. That deadline is used to allow enough time to process the refund from the trust prior to April 15th. The responsibility in this example falls to Sally. Sally should notify one of the plans that she has exceeded the §402(g) limit and must receive a refund of the excess plus attributable earnings. If Sally does not request the refund from either plan, or if no plan grants Sally’s request to distribute the excess, Sally will be taxed on the $3,500 excess in 2022 and again when there is a distributable event (i.e., upon termination, death, disability, or retirement). In other words, there is a double taxation penalty.
In this Example #1, the excess deferrals only impact the individual tax payor. Neither plan has allowed the individual to defer more than the limit for 2022, so neither plan has a §401(a)(30) violation. The excess cannot be distributed after April 15th because there is not a distributable event, nor is there a qualification failure to correct.
Example #2 (Single Employer): Jason, who is under age 50, worked for Company Z for the entire 2022 calendar year and solely participated in Company Z’s 401(k) Plan during 2022. Jason deferred $24,000 to the Company Z 401(k) plan, in excess of the §402(g) limit of $20,500. The excess deferrals of $3,500 (including earnings adjustment) MUST be distributed from Company Z’s 401(k) plan before April 15, 2023. If the excess deferrals are not timely distributed, the plan has a qualification failure under IRC §401(a)(30).
In this Example #2, it is the responsibility of Company Z to distribute the excess deferrals because failure to do so impacts the qualified status of the entire plan. If Company Z misses the April 15th deadline, the company will need to correct the failure under EPCRS. In this case, the excess will be distributed after April 15th, and unfortunately Jason will be subject to immediate double taxation.
What Are the Tax Implications to the Individual?
Excess deferrals timely distributed before April 15th: If the excess deferrals are timely distributed, the participant will include the excess in gross income for the year of the deferral (subject to ordinary income taxes, unless the excess was designated Roth deferrals). The earnings on the excess deferrals are taxed in the year the excess is distributed. Note that excess deferrals can be corrected in the same year of the deferral, after the excess is determined. Timely corrected excess deferrals are not subject to the 10% early withdrawal penalty. Any Roth deferrals were already taxed, so only the earnings would be taxable for the year of the distribution.
Excess deferrals in two or more unrelated employers not timely distributed: As in Example #1 above, the excess deferral only impacts the individual tax payor. Once the April 15th deadline has passed, the excess CANNOT be distributed. The individual will include the excess in gross income for the year of the excess deferral (2022). Because the excess remains in the plan, the second taxable event occurs when the individual takes a distribution from the plan (e.g., upon termination from employment). Oddly enough, this could postpone the second taxable event for many years.
Excess deferral through a single employer not timely distributed: As in Example #2 above, excess deferrals must be distributed to avoid plan disqualification. The individual will include the excess in gross income for the year of the excess deferral (2022) and again in the year the excess is distributed (2023). Unfortunately for the individual, the 10% early withdrawal penalty may also apply if under age 59 ½. The earnings are taxable in the year the excess is distributed.
What Are the Tax Reporting Procedures for Excess Deferrals?
Excess Deferral (First Form 1099-R):
- Taxable in the year in which the excess deferral occurred (e.g., 2022), other than excess Roth contributions
- Reported on Form 1099-R, Boxes 1 and 2a, with Code P in Box 7
Earnings Attributable (Second Form 1099-R):
- Taxable in the year of the distribution (2022 if distributed prior to 12/31/2022, 2023 if distributed 1/1/2023 – 4/15/2023)
- Reported on a second Form 1099-R, Boxes 1 and 2a, with Code 8 in Box 7
Roth Corrections (if applicable):
- Reported on a separate Form 1099-R
- Reports the total amount of the distribution in Box 1
- Reports the earnings attributable to the Roth contributions in Box 2a
- Reports the Roth contributions being returned in Box 5
- Reports the first year of the five-taxable-year period in Box 11
- Reflects Code B in Box 7, with Code 8 or P as applicable
Note: No changes are made to the employee’s Form W-2. The reporting is handled exclusively via the Form 1099-R.
What is the Impact of Excess Deferrals on Nondiscrimination Testing?
There is only an impact on annual nondiscrimination testing if the excess deferrals occur in a single employer’s plan. The excess may be counted in the Average Deferral Percentage Test (ADP Test) and will count in the annual additions test.
The treatment of the excess deferrals in the ADP Test depends on whether the affected employee is considered a Highly Compensated Employee (HCE). If the excess occurs in a single employer’s plan and the individual is an HCE, then the excess is included in the ADP Test. However, if the individual is not an HCE, the excess deferrals are excluded from the ADP Test.
Excess deferrals are counted in the annual addition’s limitation under IRC §415 for the plan year ($61,000 for 2022). The annual additions limitation includes all contributions and forfeitures allocated to a participant’s account for a plan year. Allocations provided under related employer plans are aggregated for purposes of this limitation.
Excess deferrals can be prevented by both employees and employers. When they do occur, it is very important to know how to correct them given the circumstances. Best practice is to remind all participants that even though the technical distribution deadline is April 15 following the tax year, the plan’s deadline to request any excess deferral refunds is often earlier (e.g., March 1st following the tax year). At the plan sponsor level, employers should have policies and procedures in place to review the annual employee deferral amounts through that employer’s plan (or plans) as soon as possible after December 31st each year. Preparation of the Forms W2, which the employer must furnish by January 31st, is a perfect opportunity to review employee deferrals.
Our retirement service team at Newfront is available to assist you with questions regarding excess deferrals or other retirement plan questions that may arise.
Email us at 401kHelp@newfront.com
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The information provided is of a general nature and an educational resource. It is not intended to provide advice or address the situation of any particular individual or entity. Any recipient shall be responsible for the use to which it puts this document. Newfront shall have no liability for the information provided. While care has been taken to produce this document, Newfront does not warrant, represent or guarantee the completeness, accuracy, adequacy, or fitness with respect to the information contained in this document. The information provided does not reflect new circumstances, or additional regulatory and legal changes. The issues addressed may have legal, financial, and health implications, and we recommend you speak to your legal, financial, and health advisors before acting on any of the information provided.