What are the Internal Revenue Code section 402(g)/415(c) limits?
The IRS sets limits on how much an employee (a plan participant) can contribute to a retirement plan each year, both deferring a portion of their compensation and similar personal contributions (section 402(g) limit) and combined employee and employer contributions (section 415(c) limit). Sometimes plan sponsors encounter situations where an employee or Plan Sponsor contributes too much to the plan and exceeds one or both of these annual limits. Fortunately, there are ways of fixing these errors.
What happens if my employee (plan participant) exceeds the 402(g) limit for the plan year?
It is critical to detect and correct these errors as quickly as possible. If the participant exceeds the deferral limit for the plan year, the excess deferrals must be distributed back to the participant by April 15 of the following year. Excess deferrals for the previous year that are withdrawn by April 15 of the following year are included in the employee’s gross income for the plan year. Bear in mind that the earnings on the excess deferrals are taxed in the year they are distributed. The return of the recess deferrals is not subject to the additional 10% tax on early distributions. You will also need to notify and carefully coordinate with your payroll company and Vestwell to be sure the participant's salary deferrals are adjusted accordingly.
What happens if the excess 402(g) deferral is not returned to the participant by April 15?
Any excess deferral left in the plan is taxed twice, once when contributed and again when distributed.
Excess contributions are taxed at 6% per year for each year the excess amounts remain in the plan.
What should the Plan Sponsor do if it exceeds the section 415(c) limit?
First, distribute the excess contributed beyond the annual limit to the affected employee, which the employee will have to include as income. However, the employee will not have to pay the additional 10% tax on the early distribution.
You should then transfer any forfeited employer contributions (e.g: profit-sharing or matching) to an unallocated account. These amounts are then used to reduce the employer’s contributions in the current year and, if applicable, for subsequent year(s).
What happens if the annual limits are exceeded and the participant deferred both Pre-tax and Roth contributions? Which source is distributed first?
If the participant exceeded the 402g limit for the year and deferred both Pre-tax and Roth monies, then distributions will be processed first from the Pre-tax and only from the Roth account once all Pre-tax funds have been distributed.
How does the Plan Sponsor report these excess deferral limits to the affected employee (both excess deferrals pursuant to sections 402(g) and 415(c))?
The permitted correction method is to distribute the excess deferral to the employee and to report the amount as taxable in the year of deferral and in the year distributed. These amounts are reported on the Form 1099-R.
For Roth contributions, the excess deferral will already have been reported as income in the year of deferral. However, the excess amount will be reported as taxable in the year distributed.
Notify Vestwell (or your Third Party Administrator, if your plan uses one) by March 15 of the following year that you would like the excess deferral amount, adjusted for earnings, to be distributed to the employee from the plan. Note, the April 15 date is not tied to the due date for the employee’s or employer's tax return.
As a plan sponsor, what should I do to avoid exceeding these limits?
Plan sponsors should pay careful attention to the plan limits for compliance with both sections 402(g) and 415(c) because the annual limits do change each year.
Work with your plan administrator and confirm that your administrator has sufficient payroll information to verify that the deferral limitations of sections 402(g) and 415(c) were not exceeded.
Establish your own internal procedures to ensure that, based on the employee election forms (including modifications), employees won't exceed the sections 402(g) and 415(c) limits.
Have checks and balances in place to alert you, your payroll company, and your plan administrator when the limit is exceeded to take timely corrective action.
The above is intended for informational purposes only. Vestwell is not a law firm or tax advisor. Plan sponsors should consult with their tax and legal advisors to determine what option is best for their specific situation.