401K Employer Over Contribution Dilemma

[pb4uski]

Just out of curiosity... was the 1099-R issued by Fidelity have your tIRA as the account number or the 401k plan id? IOW, was it issued by Fidelity on behalf of the 401k plan or the tIRA?

Also, the OP says $20k and the $1099-R was for $21k... was the diffence for growth? Or why were the numbers different?

 

[Ready]

It sounds like that the employer/401k reported that to Fidelity that it had made an error in letting you defer severance income and Fidelity issued the 1099-R is to offset the fact that you were allowed to make a 401k contribution in 2017 for severance income that was not eligible to be deferred. IOW, if you have your paystub after the severance payment then the severance payment was included in gross earnings but also as a 401k deduction so your W-2 erroneously showed $0 of income relating to the severance where it should have shown $20k of income and $0 401k deduction. The 2020 1099-R corrects that error (at least for the contribution part).

Go back to posts #87 and #88. I think that your situation is very similar to the situation in post #87 and that the resolution will be similiar.

Yes, in post 87 the excess contribution was distributed, which I believe is what Fidelity should have done in my case. If they distribute the money to me then my only remaining issue is being made whole on the 10% penalty, should it be assessed.

 

[pb4uski]

I don't think that the 10% penalty applies to the return of an excess contribution... but the 6%/year excess contribution penalty may apply.

But you may still come out ok if your 2020 marginal tax rate applied to the return of the excess contribution is lower than the 2017 marginal tax rate that would have applied if they did it right the first time.... if so, that may help dampen the blow.

 

[Ready]

I don't think that the 10% penalty applies to the return of an excess contribution... but the 6%/year excess contribution penalty may apply.

But you may still come out ok if your 2020 marginal tax rate applied to the return of the excess contribution is lower than the 2017 marginal tax rate that would have applied if they did it right the first time.... if so, that may help dampen the blow.

6% per year excess contribution - yikes. That's even worse than the 10% penalty since it's been three years. I certainly think the employer should make me whole for that.

 

[iloveyoga]

In my prior working life, I got involved in situations like this. I think that money will need to come out of your IRA and it sounds like you have already paid the penalties. We would usually reimburse for any applicable penalties, it was all or mostly our fault. Maybe even legal fees.....

 

[cathy63]

There is no penalty on these funds. Here are the IRS instructions for 1099-R issuers. https://www.irs.gov/pub/irs-pdf/i1099r.pdf

Distributions Under Employee Plans
Compliance Resolution System (EPCRS)

The procedure for correcting excess annual additions under
section 415 is explained in the latest EPCRS revenue
procedure in section 6.06 of Rev. Proc. 2019-19, 2019-19
I.R.B. 1086, available at IRS.gov/irb/2019-19_IRB#REVPROC-2019-19.

Distributions to correct a section 415 failure are not
eligible rollover distributions although they are subject to
federal income tax withholding under section 3405. They are
not subject to social security, Medicare, or Federal
Unemployment Tax Act (FUTA) taxes. In addition, such
distributions are not subject to the 10% early distribution tax
under section 72(t).

You may report the distribution of elective deferrals (other
than designated Roth contributions) and employee
contributions (and earnings attributable to such elective
deferrals and employee contributions) on the same Form
1099-R. However, if you made other distributions during the
year, report them on a separate Form 1099-R. Because the
distribution of elective deferrals (other than designated Roth
contributions) is fully taxable in the year distributed (no part of
the distribution is a return of the investment in the contract),
report the total amount of the distribution in boxes 1 and 2a.
Leave box 5 blank, and enter Code E in box 7.

I also just played around with TurboTax and confirmed that it doesn't calculate any type of penalty on a 1099-R with code E, even if you are under age 59 1/2. It just treats the entire amount as ordinary income.

You do have to remove the funds (plus any earnings since the date of the rollover) from the IRA. If you don't, and the IRS figures out that you didn't, then I think that's when the 6% per year penalty comes in, starting in 2020. Plus if you leave the $21K that's already been taxed in there, then you will end up paying tax again when you finally withdraw it. The main problem I see is that the $21K needed to come out of the account in the 2020 tax year to match the 1099R, not in 2021.

 

[Ready]

There is no penalty on these funds. Here are the IRS instructions for 1099-R issuers. https://www.irs.gov/pub/irs-pdf/i1099r.pdf



I also just played around with TurboTax and confirmed that it doesn't calculate any type of penalty on a 1099-R with code E, even if you are under age 59 1/2. It just treats the entire amount as ordinary income.

You do have to remove the funds (plus any earnings since the date of the rollover) from the IRA. If you don't, and the IRS figures out that you didn't, then I think that's when the 6% per year penalty comes in, starting in 2020. Plus if you leave the $21K that's already been taxed in there, then you will end up paying tax again when you finally withdraw it. The main problem I see is that the $21K needed to come out of the account in the 2020 tax year to match the 1099R, not in 2021.

Looking at the last paragraph of that publication, it says

“Because the distribution of elective deferrals (other than designated Roth
contributions) is fully taxable in the year distributed”

This is where I still see a problem that needs to be resolved. While the 1099-R is for tax year 2020, the funds still have not been distributed. So the year of distribution has not yet been determined. I’m assuming the resolution is going to be Fidelity distributing the funds to me this year but I won’t know until they get back to me with their proposed solution.

 

[Ready]

I spoke to a tax professional and here is what she told me:

1) The funds are not subject to any penalties - neither early withdrawal nor excess contribution.

2) I need to pay federal and state tax, but I do not need to pay SS or Medicare tax, so there is a slight windfall for me. I’m also in a lower tax bracket now that I’m retired, so that’s another minor windfall.

3) I can leave the money in the IRA but report it as part of my cost basis so that when I withdraw it I’m only paying taxes on the gains in my account and not the cost basis. I recall also contributing after tax dollars each to year my IRA that will be a part of my basis as well, so this would get added to those funds.

4) If I want to withdraw the money I can do so but Fidelity will need to code it to reflect matching up with the 1099-R rather than having it look like a new transaction that would be subject to a second round of taxes and possible penalties.

So I guess this all makes sense and makes it far less complicated than I was thinking it might be. Does leaving it in the IRA but reporting it as cost basis sound right? I’m a little fuzzy on how to keep track of the cost basis as I’ve been contributing the $5,500 in after tax dollars now for many years but I have not been personally keeping track of it. Is that my job or does Fidelity keep records of those contributions and record them as after tax contributions and therefore not subject to additional taxes when withdrawn?

 

[N02L84ER]

I think you are supposed to be filing Form 8606 every year you make a non deductible IRA contribution.

 

[Ready]

I think you are supposed to be filing Form 8606 every year you make a non deductible IRA contribution.

Yes, I have been. But my last contribution was in 2016 and I’m 18 years away from my first planned withdrawal from my IRA. So I have no idea if I’m going to remember how to find an 8606 form I filed more than twenty years ago. I guess I’ll cross that bridge when I get to it though.

 

[statsman]

So, they are effectively treating this as a non-deductible IRA contribution, in addition to making it income + gains that needs to be taxed. Interesting in that it exceeds the limit for non-deductible IRAs in a single year. I guess leaving it alone will allow for the deferral of any future gains going forward.

 

[Ready]

I’m hoping Fidelity will find a way to move the funds to a Roth IRA so that I don’t have to keep track of the cost basis for the next 30 years. It looks like I have until April 15th to move funds “earned” in 2020 to a Roth.

 

[pb4uski]

I spoke to a tax professional and here is what she told me:

1) The funds are not subject to any penalties - neither early withdrawal nor excess contribution.

2) I need to pay federal and state tax, but I do not need to pay SS or Medicare tax, so there is a slight windfall for me. I’m also in a lower tax bracket now that I’m retired, so that’s another minor windfall.

3) I can leave the money in the IRA but report it as part of my cost basis so that when I withdraw it I’m only paying taxes on the gains in my account and not the cost basis. I recall also contributing after tax dollars each to year my IRA that will be a part of my basis as well, so this would get added to those funds.

4) If I want to withdraw the money I can do so but Fidelity will need to code it to reflect matching up with the 1099-R rather than having it look like a new transaction that would be subject to a second round of taxes and possible penalties.

So I guess this all makes sense and makes it far less complicated than I was thinking it might be. Does leaving it in the IRA but reporting it as cost basis sound right? I’m a little fuzzy on how to keep track of the cost basis as I’ve been contributing the $5,500 in after tax dollars now for many years but I have not been personally keeping track of it. Is that my job or does Fidelity keep records of those contributions and record them as after tax contributions and therefore not subject to additional taxes when withdrawn?

Great result.

I'm surprised that you would have the option of leaving it in the IRA and reporting it as cost basis but perhaps that is because the excessive contribution is not your mistake.

The only advantage of leaving it in the IRA is tax deferred growth and assuming that your marginal tax rate now and marginal tax rate later are probably pretty similar I don't see much advantage to leaving it in the tIRA.

I would just take the money and growth out so you don't have to track cost basis in your tIRA... especially as you get older and your cognitive skills decline. Obviously, just make sure that Fidelity codes it correctly so you don't get taxed twice.

 

[cathy63]

Great result.

I'm surprised that you would have the option of leaving it in the IRA and reporting it as cost basis but perhaps that is because the excessive contribution is not your mistake.

The only advantage of leaving it in the IRA is tax deferred growth and assuming that your marginal tax rate now and marginal tax rate later are probably pretty similar I don't see much advantage to leaving it in the tIRA.

I would just take the money and growth out so you don't have to track cost basis in your tIRA... especially as you get older and your cognitive skills decline. Obviously, just make sure that Fidelity codes it correctly so you don't get taxed twice.

I'm also quite surprised that the tax advisor says it's o.k. to leave it in the tIRA. If Ready hadn't already rolled over the account, the former employer definitely would have had to remove the money from the plan and cut her a check. There wouldn't have been an option to leave the money there, so it seems strange that the rules changed just because the money had left the employer's control before they discovered the error.

It sounds like Ready has made non-deductible contributions and filed form 8606 in the past, so she's already tracking a basis in her IRA. She does have to find the last 8606 she filed in order to carry that data forward to her 2020 return though.

 

[Ready]

I’m not sure how well the tax advisor thought through the IRA contribution limits in answering my questions. I’m still waiting for the manager at Fidelity that I spoke with to get back to me with a proposed solution. Since they are the custodians of the funds they should know whether or not this can be done. But as it stands the money is still in there so I guess for now it appears that I could leave the money in there.

However, if I file an 8606 form this year showing a $21K contribution that might raise a flag with the IRS.

 

[Ready]

I posted my question on the IRAHelp forum and received this reply. If I’m understanding the response correctly it sounds like the best course of action is to remove $21K from the IRA to match the 1099-R, and no penalties should apply for doing so.



This is called a plan overpayment and these obviously have very ugly implications. The first one is the 1099R which tells you and the IRS that 21,000 of the amount you rolled over was an excess plan contribution and therefore not eligible for rollover. It does not matter whose fault this was. Some DB plans even attempt to claw back DB pension payments made for decades if they find a calculation error (or the DOL does in an audit).

Since your 401k and IRA are different plans, even though FIdelity might be told of the excess IRA contribution, they have no authority to just distribute it since you have the right to apply it as later year IRA contributions you might have been eligible for but not made, or you might also have taken an IRA distribution in the meantime that would have offset the IRA excess. Both of these are done on Form 5329 by simply following the 5329 instructions.

In theory you also have the option of paying the IRA excess contribution excise tax or 6% each year, although that is very costly and only beneficial in some cases in the first second year to protect the earnings on the IRA excess. You are past that now, and to correct the excess IRA contribution you only need to request a normal distribution of 21,000 with no mention of an excess and any earnings remain in the IRA. This distribution is reported on Form 1040 and Form 5329 as mentioned above. Otherwise, you owe the 6% excise tax for 2017-2020 (4 years) and there is no IRS Statute of Limitations on excess IRA contributions. Attempting to treat the 21000 as a non deductible IRA contribution is not valid (it would still be excess and exceed the contribution limit), so forget that idea. If you decide to leave the excess in the IRA that would be playing the audit lottery and the E coded 1099R will be a large red flag to the IRS.

The other big issue is the actual clawback. Some plans are aggressive and other plans may not pursue collection. No telling how aggressive your plan might be. Many in your shoes hold out on repayment and the plan may back off. Some participants have been known to offer repayment less the amount these additional taxes and penalty have cost them due to the plan error.

Nothing you can do about the 2020 1099R as it is not incorrect. It treats the 21,000 as distributed from the plan along with the eligible rollover funds. The code E will be treated by tax software as taxable income for the year of the 1099R, which I assume is 2020. You will not have to amend prior returns. On your 2020 return I am not sure whether the 21000 will be added to the wages line or the pension distribution line 5. Even if you are under 59.5, there is no 10% penalty on an E coded corrective distribution.

Now lets assume that you DO eventually repay the 21000 to the plan. In order to address the taxes you paid on income that was clawed back, you should qualify for a "Claim of RIght" deduction or credit per Sec 1341. Applicable IRS Reg added below:
21.6.6 Specific Claims and Other Issues | Internal Revenue Service (irs.gov)

 

[Ready]

I've had another update on my ongoing 1099 rollover saga. I've been going back and forth with the attorney for my former employer and he sent me an email today informing me the company is going to "issue a revised 1099 to exclude the rollover of the profit sharing plan". I asked him if this effectively reverses the 1099 and he said "I assume so".

So while it's a little murky, I think they have agreed to reverse the 1099 and consider the entire amount a 401K to IRA rollover.

I have a call in to Fidelity to find out how quickly this can be done and whether they can send me the corrected 1099 this year, or if it will not go out until next year because it's a 2021 transaction.

My question is, how do I handle this on my taxes if I don't get the corrected 1099 prior to April 15th? My inclination is to file my tax return without including the 1099 for the $20K but to include a copy of it along with a letter explaining that it was issued in error and the company has agreed to issue a reversal. Is that the best way to go or is that setting me up for problems with the IRS?

 

[cathy63]

I've had another update on my ongoing 1099 rollover saga. I've been going back and forth with the attorney for my former employer and he sent me an email today informing me the company is going to "issue a revised 1099 to exclude the rollover of the profit sharing plan". I asked him if this effectively reverses the 1099 and he said "I assume so".

So while it's a little murky, I think they have agreed to reverse the 1099 and consider the entire amount a 401K to IRA rollover.

Wow, that's great. I'm really shocked that the IRS will allow them to reverse this transaction though since plans are legally required to correct these types of errors even if they're not discovered for a few years. I don't see how they're going to get away with this, but maybe they've found some way to absorb the costs themselves.

I have a call in to Fidelity to find out how quickly this can be done and whether they can send me the corrected 1099 this year, or if it will not go out until next year because it's a 2021 transaction.

My question is, how do I handle this on my taxes if I don't get the corrected 1099 prior to April 15th? My inclination is to file my tax return without including the 1099 for the $20K but to include a copy of it along with a letter explaining that it was issued in error and the company has agreed to issue a reversal. Is that the best way to go or is that setting me up for problems with the IRS?

I think if it were me and I didn't know whether I'd be getting a 1099 for 2020 or 2021, I'd file for an extension in April and pay the tax on the $20K. Then if the corrected 1099 comes in for 2020, you can file a correct return and get the tax refunded by October 15. If it still doesn't come in by October 15th, then including a letter stating that the 1099 was issued in error seems like the way to go.

If they tell you the correction will be issued as a 1099 for 2021, I have no idea what to do. I don't think there is a way to revoke a prior 1099 by issuing one for a subsequent year, so I don't know what a 2021 1099 would even say. It would have to show a negative amount somehow, which doesn't make sense.

 

[pb4uski]

If you don't get the corrected 1099 in time could you file a Form 4852 showing your best estimates of the correct amounts?

... If you don't receive the missing or corrected form in sufficient time to file your tax return, you may use Form 4852 to complete your return. Estimate your wages or the payments made to you and any taxes withheld and report them on Form 4852. ...

https://www.irs.gov/taxtopics/tc154

 

[Ready]

Thanks Cathy63 and Pb4uski! I spoke to Fidelity tonight and they confirmed they would be issuing a corrected 1099 for 2020. They think it’s just going to be a revised 1099 showing that the $20K was rolled over to an IRA and therefore non-taxable.

I will wait until we get closer to April 15th to see if I have the corrected 1099 in time to file a timely tax return. If not I guess I’ll have to go with the extension and pay the taxes as if the $20K was still taxable.

 

[Ready]

My former employer reversed course on me and told me to go pound sand and left the 1099 as is. So I went ahead and paid the taxes on it. I finally found an Enrolled Agent who would take my call and help me work though what to do now. As it turns out, because the 1099 was issued in 2020 I will not have to pay any penalties for excess contributions. So I have two choices:

1) Leave the money in my IRA and add it to my cost basis.
2) Withdraw the money from the account and put it in a taxable account.

If I leave the money in I would have to file an updated form 8606 to update my cost basis. I’m 18 years away from RMDs. If I remove the money from the account it will generate a second 1099, so I’ll have to figure out how to report it next year so that I don’t pay taxes on it twice.

My question is, is there any particular advantage to leaving it in at this point, since the gains on the money would grow tax deferred for another 18 years? Or is it better to pull the money out so I don’t have to track the basis?

 

[pb4uski]

I don't think it makes any difference if the tax rate is the same. Let's say the amount involved is $100 and the tax rate is 20%.

If you leave it in and it triples in 18 years to $300 and you take it out you have $240.

If you take it out now and pay 20% and invest the $80 and it triples in 18 years then you have $240.

So I don't think it makes enough of a difference to fret about. What does you EA think you should do?

 

[Ready]

I don't think it makes any difference if the tax rate is the same. Let's say the amount involved is $100 and the tax rate is 20%.

If you leave it in and it triples in 18 years to $300 and you take it out you have $240.

If you take it out now and pay 20% and invest the $80 and it triples in 18 years then you have $240.

So I don't think it makes enough of a difference to fret about. What does you EA think you should do?

He said pretty much the same. His biggest concern with leaving it in is that if I pass and the money goes to my heirs they will have no idea about the cost basis.

My concern with taking it out is it will generate a second 1099. He said there is a way to report it on next year’s taxes as basis so that I’m not paying the taxes on it twice but I’m not exactly sure what the mechanics are to do so. And if I enter a 1099 with a different distribution code than what is reported to the IRS, do I open myself up to a potential audit?

 

[pb4uski]

He said pretty much the same. His biggest concern with leaving it in is that if I pass and the money goes to my heirs they will have no idea about the cost basis.

My concern with taking it out is it will generate a second 1099. He said there is a way to report it on next year’s taxes as basis so that I’m not paying the taxes on it twice but I’m not exactly sure what the mechanics are to do so. And if I enter a 1099 with a different distribution code than what is reported to the IRS, do I open myself up to a potential audit?

I would take it out and seek his advice on your report it on your 2021 return so you don't pay tax on it twice... even if you have to engage him to do your 2021 return or review the 2021 return that you have prepared.

 

[N02L84ER]

This is not your only traditional IRA, right? Correct me if I am wrong, but I think that since you already have other traditional IRA money, you cannot just withdraw this basis and all withdrawals will be prorated on how much is considered already taxed based on form 8606.