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I got a return of contributions to my 401(k). What do I do?

with 20 comments

I’ve had to file more than one amended return in this situation, with penalties and interest accruing to the taxpayer, and I thought this would be a good place to start.

You manage a local retail branch of a small regional chain. Your employer offers a 401(k) plan, in which you choose to participate, donating the maximum allowed. You get your W-2 in January, and it shows the amount you deferred in Box 12 with code D. In February, you get a check in the mail from your 401(k) plan administrator. The check comes with a note that says your company’s 401(k) plan failed a test, and to bring the plan into compliance some of your “excess contributions” are being returned to you, along with any interest those contributions earned during the period they were invested in your plan. You are puzzled but do nothing, and file your taxes normally. One year later, you receive a Form 1099-R from the plan administrator showing a distribution in the amount of the check, with Code 8 in Box 7. You file it with your return accordingly, and are stunned to get a letter from the IRS in July claiming that you owe back taxes on that income from two years ago.

401(k) plans cannot be biased in favor of highly-compensated employees (HCEs, defined as anyone who owns at least 5% of the company, and anyone who makes more than a defined dollar amount). If HCEs contribute too much more to the 401(k) plan than do non-HCEs, as a percentage of income, the plan is non-compliant and must be brought into compliance. Frequently, this is done by refunding enough of the contributions made by the HCEs to bring the percentages contributed by HCEs down to the required level. (The employer can also make a contribution on behalf of the non-HCEs to bring their percentage up, but this doesn’t happen as often, in my experience). The refund must include not only the excess contribution but also any income earned by those contributions during the period of time they were invested in the plan.

Those distributions – both the return of contributions and the income earned – are taxable in the year the contributions to the 401(k) were made, even though the return distribution isn’t made until the following year. They are treated as though they were never made - they should have been part of your taxable wages for that year on your W-2 – and you have to treat them the same way on your return.

If you get a check for return of excess 401(k) contributions in 2010, you must include the amount that you received as wages on your 2009 return.

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Written by nctaxpro

November 19, 2009 at 2:20 pm

Posted in Retirement, Taxes

20 Responses

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  1. This rule has been changed. The distribution is now taxable in the year you receive it. Your comment was true in the past.

    David Carlson

    March 9, 2010 at 12:43 pm

    • You are correct; the rule changed beginning with the 2008 tax year. Thanks for the correction!

      nctaxpro

      March 9, 2010 at 7:16 pm

    • So the money returned to me yesterday for my overpayment to the 401K for 2009 can be filed with my 2010 income without a back-tax penalty from the IRS and without filing an amended return for 2009?

      Rob Boston

      March 20, 2010 at 2:22 pm

      • Rob:

        It depends on why you overpaid. There are two reasons why you could have overpaid:

        1. You deferred more than the allowable limit – generally $16,500 for 2009. In this case, you do have to report the income on your 2009 return (unless it was an excess deferral to a designated Roth plan).
        2. You were a highly compensated employee, and your plan didn’t meet the qualifying requirements (the situation I wrote about). In this case you report the income on your 2010 return.

        This is discussed in IRS Publication 525, on page 10.

        nctaxpro

        March 22, 2010 at 8:15 am

  2. Thanks for the help. It was because I was an HCE. THe publication helped as well. Thanks again.

    Rob Boston

    March 22, 2010 at 1:46 pm

  3. I have the same situation. HCE, deferral (2009) + income returned between Jan 1 and April 15 2010.

    I read IRS publication 525 and the Excess deferrals section, paragraph 2, it says explicitly “You must include the excess deferral in your income for the year of the deferral unless…” (the unless conditions do not apply to me). So why does David Carlson say it is taxable in the year you receive it?

    Further along, it says under “Excess distributed to you”, third bullet, (they are talking about a 2009 1099 for excess deferral in 2008, distributed in the beginning of 2009), that if you didn’t declare this income on line 7 of your previous tax return (in their case 2008, but in my cause it will be 2009), then file a 1040X amended return. Won’t this trigger penalties for the tax owed on this money?

    Two more questions:

    The check I got includes the excess deferral and earnings. Can I just treat this income all the same?

    I am using TurboTax, any idea how to enter this extra income (line 7) without a 1099 in hand?

    Thank you!

    ES

    March 27, 2010 at 12:39 am

    • There are two different types of returns on contributions.

      Excess deferrals occur when the employee’s elective deferrals exceed the maximum allowed by the plan, typically $16,500 for 401(k). If your return of contributions results from an excess deferral, then you include the amount as compensation in the year that the compensation was deferred.

      Excess contributions, which is your situation, occur when the employee is an HCE and contributed more than the allowable amount based on the average deferral percentage of all eligible non-HCE. Before the 2008 tax year these were treated in the same way as excess deferrals. Now, however, per Pub 525:

      If you receive a corrective distribution of excess contributions (and allocable income), it is included in your income in the year of the distribution.

      which means you report it on your 2010 return, next year.

      If you do have to deal with a return for 2007 or earlier (as I did), normally you have to create a substitute W-2.

      nctaxpro

      March 28, 2010 at 11:35 am

  4. Very clear, thank you so much. For some reason, glancing at the contributions section made me think of other types of contributions, like company matches, so I didn’t think that was my case but now I see that it is. Thank you again, big help!

    ES

    March 28, 2010 at 11:47 pm

  5. Hi

    Very great helpful information.

    Regarding the last point, can the excess contribution (I am an HCE) be :

    1. rollover to a Traditional IRA for the year the excess contribution was received or previous year, within 60 days, to avoid the taxation ? ( I would

    then instruct the plan admin to change box 7 of 1099-R to reflect the rollover )

    2. or, contributed to a non-working spouse’s Traditional IRA (qualified – as my income is less than $177,000) in the year the excess contribution was

    received or previous year to reduce taxes ?

    In the case of previous years, assuming it was done before April 15 of current year.

    Thanks for your reply

    Alex

    Alex

    March 24, 2011 at 5:11 am

    • Alex:

      You can’t roll over a 401(k) excess contribution to your IRA. By definition, an excess contribution is not qualified to have tax deferred, period.

      In your circumstance, your wife can contribute up to $5000 ($6000 if she is over 50) to a traditional IRA. Her contribution is fully deductible if your adjusted gross income is less than $167,000, partially deductible if AGI is between $167,000 and $177,000, fully nondeductible if AGI is $177,000 or more. Any part of a contribution to an IRA that is nondeductible is reported to the IRS on Form 8606. See http://www.irs.gov/publications/p590.

      nctaxpro

      March 24, 2011 at 9:40 am

      • Thanks for this very informational post. I recently received some excess contribution back from my 401k due to the plan not meeting discrimination test (I am an HCE). From your above comment, I understand this will be taxable on my 2012 return next year. I have two questions:

        1. Will I also pay the 10% penalty on this excess contribution?
        2. Can I put this refund check in my IRA account and claim a tax benefit in my 2011 tax return, which I am going to file in a few days?

        Thanks in advance.

        Vishal

        February 23, 2012 at 6:54 pm

      • Hi Vishal:

        1. You do not have to pay the additional 10% penalty on the excess contribution – for tax purposes it is treated as though it were never made in the first place.

        2. A return of your excess contributions to a 401(k) cannot be rolled over to your IRA. If you are eligible to make a deductible contribution to your traditional IRA, you can of course do that up until April 17th and have the contribution be credited as being made in 2011. You are eligible for a deductible contribution to a traditional IRA when covered under a 401(k) if your adjusted gross income is less than $66,000 if single ($110,000 if married filing jointly), with phase-outs applying if your AGI is between $56,000 and $66,000 ($90,000 and $110,000 if married filing jointly). AGI, for this purpose, includes deductions for student loan interest, tuition and fees, and a couple of other things listed in .

        nctaxpro

        February 28, 2012 at 10:34 am

  6. I have a 1099-R for $6418.97 and federal income tax has already been withheld at $641.89. In box 7, is an 8. When I enter it into Turbo Tax it deducts another $1900.00. Is this correct?

    Shannon

    March 7, 2012 at 1:48 pm

    • Shannon:

      Were any of the contributions designated Roth contributions? Check Box 5 of the 1099-R. Otherwise, you probably need to contact Turbo Tax tech support.

      nctaxpro

      March 7, 2012 at 3:28 pm

      • Box 5 is empty.

        Shannon

        March 7, 2012 at 3:34 pm

  7. Similar situation.
    HCE, return of $4099 in march of 2011. I applied all of it to the 2011 tax year (no cash to me) I received a 1099-R for 2011. Boes 1,2,4 have $4099 Box 7 has code 8. Nothing else checked.

    When entering this into Turbo tax, my taxes go up by $1947…..roughly 47.5% That seems a bit steep. Any ideas why this would be happening?

    Michael B

    April 4, 2012 at 8:14 pm

  8. This HCE stuff is a crock. I just have to get that off my chest. I am not in “upper management” being given some special financial incentives. I just happen to be highly skilled and highly paid. I am 52 years old and finally in a position to plow some money into retirement, and I get screwed by this HCE stuff. If I was NOT HCE, I could save MORE for retirement. I undertand that the intention was to prevent intentionally skewing 401k plans to benefit upper management, but it fails. There are plenty of HCE employees in IT contract positions, and we are merely discouraged by this from contributing to 401k plans at all. Since you have no idea what the HCE limit will be until it is too late, you’re better off not participating. That was not the intent of this law, but it certainly is the result.

    kbbpll

    April 14, 2012 at 7:04 pm

  9. Great information!

    Sharon

    May 7, 2012 at 7:57 am

  10. In January 2011, I contributed the full amount I was told I could contribute for the year into the company 401K. The job terminated unexpectedly in February 2011. I rolled over the entire amount into an IRA in April 2011. It is now May 2012, and I just received a letter from the old job that they are planning to send me a 1099R as their 401K failed the HCE test and told me I must withdraw the amount from the IRA so they can be compliant. My broker suggested that they may need to issue me a 1099R as well for withdrawing the funds from them. This would mean that I am getting 2 – 1099 R’s for the very same issue. The former employer suggests, instead, that I rollover the excess from the existing IRA and put it back into their 401K. Then they will issue the only 1099R for the year 2012 and also retain 20% tax. As I have not been employed with them since 2011, what ramifications does this have to me? Can you suggest how to deal with this without incurring any penalties? I will declare the excess as income in 2012 per previous comments on your blog. Thanks for your help.

    Angelo

    May 24, 2012 at 10:53 pm

  11. It is perfect time to make some plans for the future and it’s time to be happy. I’ve read this submit and if I may just I want to recommend you some interesting things or advice. Perhaps you could write subsequent articles referring to this article. I desire to learn more issues about it!

    direct to consumer

    July 13, 2012 at 5:40 pm


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