What to Do If You Mistakenly Take Deferrals Out of a Participant’s Pay Pre-Tax When They Elected Roth
Most plan sponsors have the best of intentions in operating their 401(k) plans correctly. But mistakes happen to even the best of them. So what is a plan sponsor to do if an employee made a Roth deferral election but the employer took the money and contributed it on a pre-tax basis instead? In its latest newsletter the IRS details out the correction method. This newsletter was helpful guidance as this issue has not previously been addressed in the IRS’s Employee Plan Compliance Resolution System correction program.
The obvious portion of the fix is that the plan sponsor must transfer the deferrals, adjusted for earnings, from the pre-tax account to the Roth account. Next the employer has to correct the taxation issue, as the employee should have been taxed on these deferrals at the time they were contributed to the plan. If it happened in a prior year, the IRS provides that the employer can issue a corrected Form W-2. This option will likely be an unpopular one with employees as it would require them to file an amended tax return. The IRS goes on to provide that you can include the amount transferred from pre-tax to Roth in the employee’s compensation in the year it is transferred. However, if you mistakenly, contribute the amounts as Roth when they should have been pre-tax, the IRS newsletter provides that the only option for correction of an error that occurred in a prior year is to complete the transfer and issue a corrected Form W-2.
Errors such as this can be self-corrected if corrected by the last day of the second plan year following the year of the error or if the error is insignificant. An error such as this would most times be considered insignificant. The plan sponsor also has the option of applying to the IRS’s Voluntary Correction Program, but that comes with a fee. If you find you have such an error and need help with its correction, please let us know.