401(k) corrective distribution for HCE

[benpthompson]

I have a dilemma that I am having trouble understanding. For the first year my wife contributed to her 401k. She maxed out the 401k at 17k. However, she is just learning that she is within the Highly Compensated Employee status and cannot contribute this much to her 401k. My question is what happens now? She has put the money in continuously over the year. Does her 401k provider send a check for the difference? What happens to the gains made with the excessive contributions? Is there a penalty for having this money in the account illegally? Her HR director and the 401k provider representative have no idea what the answers to these questions are. I need some boglehead help, please.

Lastly, she has already received her W2 form with the 17k deducted. I assume she needs to request a new W2 after the appropriate changes have been made?

Thank you!!

[livesoft]

First, there is no penalty. Her employer will send her a check for the amount that she should not have contributed. She will also get a 1099R for this. The rules have changed a little bit since the last time this happened to me.

[She will need to declare the income on her 2012 tax return even though she gets it in 2013. <-Wrong. See replies below.] It will be added to line 7 on Form 1040 where her W2 income goes (His/Her Wages, is that line 7?). So do not file until this money comes in. The 1099R will not be received until February 2014 though, but you want to do the right thing on your 2012 return so that you do not have to have an amended return. No change was ever needed for my W-2 when this happened to me.

As for the earnings, I forget whether they will be taxed in 2012 or 2013. I suppose one of the forum's resident accountants will be able to help out on that.

Here's a link to read: http://nctaxpro.wordpress.com/2009/11/1 ... ributions/ Once again, notice that the laws have changed slightly (see the comments in the link at the bottom and Publication 525 p. 10)

[benpthompson]

First, there is no penalty. Her employer will send her a check for the amount that she should not have contributed. She will also get a 1099R for this. The rules have changed a little bit since the last time this happened to me.

She will need to declare the income on her 2012 tax return even though she gets it in 2013. It will be added to line 7 on Form 1040 where her W2 income goes (His/Her Wages, is that line 7?). So do not file until this money comes in. The 1099R will not be received until February 2014 though, but you want to do the right thing on your 2012 return so that you do not have to have an amended return. No change was ever needed for my W-2 when this happened to me.

As for the earnings, I forget whether they will be taxed in 2012 or 2013. I suppose one of the forum's resident accountants will be able to help out on that.

Here's a link to read: http://nctaxpro.wordpress.com/2009/11/1 ... ributions/ Once again, notice that the laws have changed slightly (see the comments in the link at the bottom and Publication 525)

Livesoft, you are always so helpful. Thank you. Do you know by chance whether or not this effects anything with her IRA? I think the answer is no, but I just want to make sure. We did a backdoor Roth for her this year. She has no monies within a Traditional IRA.

[cherijoh]

Does her plan include an option to put in after-tax dollars? At a former employer, we could put in up to 15% of our salary, but were limited in pre-tax dollars to the current IRS limit or the maximum for highly-compensated employees (if that applied). The remainder (i.e., after-tax contributions) could stay in the plan and be tax-sheltered with respect to earnings. When I rolled my 401-k over after leaving that job, I had a basis in my rollover IRA equal to my after-tax contributions.

If such an option exists, that may be the default for her company.

[nisiprius]

It happened to me. It's what livesoft says.

It's no biggy, just a nuisance in filling out the tax forms. And of course you ultimately pay back the tax break you temporarily got on the excess contribution. I forget the sequence of events, but basically you just sit around and stuff comes in the mail and you just follow all the directions about what to do that pertain to a 1099-R form.

As I recall it goes something like this. You contribute too much in year X. In year X + 1, the 401(k) provider spits your excess contribution back to you by mailing you a check. That check is taxable income in year X + 1, and early in X + 2 you get a 1099-R form declaring it, and you write it in some appropriate box on your year X + 1 tax forms and pay the taxes. Or something like that.

It's not considered naughty or anything. It's all routine, you just save the stuff you get in the mail and follow directions. And if you're not quite sure what to do, there aren't any nuances in interpretation, it's just the sort of thing where you can call up the IRS at 1-800-829-1040 and they'll tell you step A, step B, step C.

The challenge is to figure out how much it's safe to contribute in future years if you don't want to go through the rigamarole again. It has to be a guess, HR isn't going to be able to tell you the exact number in advance.

Your wife might consider suggesting to management that they be less stingy with the 401(k) match and get more employees contributing... and, of course, if she doesn't have a Roth IRA already, she should get one, and if she cuts back on her 401(k) contributions to avoid overcontributing she should contribute correspondingly more to the Roth.

Ah, 'tis a hard, hard life for HCE's.

P.S. Also, if it hasn't happened to her already... she wants to be circumspect about mentioning the increase in her paycheck that she'll get when she maxes out her Social Security contribution for the year and they quit deducting it. Don't do what I did, which was to blurt out to a colleague, "Hey, this is funny, my paycheck is a little larger this month... is yours? do you know why?" because, of course, by disclosing the month in which you max out your Social Security contribution you are also disclosing your income.

[tfb]

However, she is just learning that she is within the Highly Compensated Employee status and cannot contribute this much to her 401k.

Learning from whom? If it's from the plan administrator or HR, she just follows instructions that will come. It appears that's not the case because you said her HR director and the 401k provider representative have no idea. Just because she's an HCE doesn't mean her contributions will be limited or returned. Many HCEs contribute the maximum just fine.

[WhiskeyJ]

She will need to declare the income on her 2012 tax return even though she gets it in 2013. It will be added to line 7 on Form 1040 where her W2 income goes (His/Her Wages, is that line 7?).

Sounds like with the 2008 changed rules it can all be handled on the 2013 return. Is that correct?

[livesoft]

^I do not know for sure, but you are probably right. A problem is that things have changed and many of the search hits are not up to date. I haven't had to mess with this myself since way back.

[Alan S.]

She will need to declare the income on her 2012 tax return even though she gets it in 2013. It will be added to line 7 on Form 1040 where her W2 income goes (His/Her Wages, is that line 7?).

Sounds like with the 2008 changed rules it can all be handled on the 2013 return. Is that correct?

Yes, things changed about 5 years ago. When the excess contribution is distributed with earnings, the amount distributed is added to line 7 wages IN THE YEAR distributed. The 1099R for this will therefore be a 2013 1099R with Code 8 in Box 7. All earnings calculations end effective 12/31 of the contribution year. Again, the distribution is NOT added to 2012 wages.

[benpthompson]

She will need to declare the income on her 2012 tax return even though she gets it in 2013. It will be added to line 7 on Form 1040 where her W2 income goes (His/Her Wages, is that line 7?).

Sounds like with the 2008 changed rules it can all be handled on the 2013 return. Is that correct?

Yes, things changed about 5 years ago. When the excess contribution is distributed with earnings, the amount distributed is added to line 7 wages IN THE YEAR distributed. The 1099R for this will therefore be a 2013 1099R with Code 8 in Box 7. All earnings calculations end effective 12/31 of the contribution year. Again, the distribution is NOT added to 2012 wages.

So to clarify, this will not effect our 2012 taxes? She will essentially deduct the entire 17k, but the excessive contribution amount + gains will be added to our 2013 taxes?

[tj]

She will need to declare the income on her 2012 tax return even though she gets it in 2013. It will be added to line 7 on Form 1040 where her W2 income goes (His/Her Wages, is that line 7?).

Sounds like with the 2008 changed rules it can all be handled on the 2013 return. Is that correct?

Yes, things changed about 5 years ago. When the excess contribution is distributed with earnings, the amount distributed is added to line 7 wages IN THE YEAR distributed. The 1099R for this will therefore be a 2013 1099R with Code 8 in Box 7. All earnings calculations end effective 12/31 of the contribution year. Again, the distribution is NOT added to 2012 wages.

So to clarify, this will not effect our 2012 taxes? She will essentially deduct the entire 17k, but the excessive contribution amount + gains will be added to our 2013 taxes?

I believe the gains stay in the 401(k) - it's the excess contributions that get returned. Though I could be wrong - regardless it will be noted on the 1099 for 2013.

[Alan S.]

No, the gains generated on the excess contribution through 12/31 of the year of the contribution are distributed along with the contribution itself. Both are taxable in the year distributed. If the plan recharacterizes the excess contribution as after tax contributions, the amounts stay in the plan but the 1099R is the same. The only difference is that you do not receive a distribution.
REF: Pub 525, p 10.

[livesoft]

Just wanted to bring up that there is a difference in tax year that a "corrective distribution" should be reported on one's return depending on the reason for the corrective distribution. That's another reason why this is all so confusing.

Although this thread is about a 401(k) corrective distribution because of HCE issues, another kind of corrective distribution occurs when one has an excess deferral simply from deferring too much from paychecks. This might occur if one worked for two different employers in the same year and overcontributed because the $17,000 or $22,500 limit in 2012. For example, suppose one contributed $23,000 in total, so they ask their 401(k) provider for a $500 corrective distribution in 2013. That $500 should be reported on 2012 taxes even though the 1099-R will be received in 2014. The 401(k) provider will also withdraw the calculated earnings that the $500 earned which complicates things. I will not describe this further here because bad things happen especially when the corrective distribution occurs AFTER April 15th. I don't know what happens if instead of earnings, one realized losses.

Accountants on the forum should feel free to tell me I'm wrong, but if I'm right it would be nice to learn that, too.

Suffice it to say, one should read the relevant tax publications carefully.