Employee Benefits-IRS Reminds Us That The Failure To Distribute Excess Deferrals May Lead To Plan Disqualification Or Double Taxation

In the Spring 2010 employee plans news, the Internal Revenue Service (the “IRS”) noted that the failure to distribute a participant’s excess deferrals from a plan may lead to the disqualification of that plan or to the participant being taxed twice. Here is the IRS explanation:

An excess deferral is a plan participant’s elective deferrals that exceed the annual elective deferral limit. For 2009 and 2010, the annual elective deferral limits are: $16,500 ($22,000 if a participant is age 50 or older) for 401(k) (non-SIMPLE) plans and 403(b) plans; and $11,500 ($14,000 if a participant is age 50 or older) for SIMPLE plans. When an employee’s elective deferrals made to one employer’s plan exceed the annual limit, the plan must distribute the excess plus earnings by April 15 following the year of excess to meet plan qualification requirements.

If an employee participates in two plans of unrelated employers and has excess deferrals, but does not exceed the limit in either plan, the employee can notify one of the plans of the excess deferrals and ask to have them distributed along with earnings by April 15. Although most plans accommodate such participant requests, they are not legally required to do so when there are no excess deferrals considering just that plan.

Excess deferrals are includible in the employee’s gross income in the year deferred, while any gains or losses on the excess deferrals are reported in the year distributed. However, if the plan does not distribute the excess deferrals and earnings to the employee by April 15, the excess deferrals must be included in gross income both in the year of deferral and in the year they are actually distributed. In other words, the excess deferrals are taxed twice! If a plan fails to distribute excess deferrals when required, it can use the correction programs under the IRS’s Employee Plans Compliance Resolution System to avoid plan disqualification.