401k Frequently Asked Questions
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Question:
Participant Can't Assign Account Balance - A participant in a 401(k) plan pledged his account balance as collateral for a personal loan. He has ceased making payments on that loan and now the bank has contacted us. What should we do?
Answer:
Nothing. (you could laugh, but that's not really polite). 401(a)(13) of the Code and 1.401(a)-13(b) of the Regulations contain the anti-alienation provisions. As a general rule, benefits may not be assigned or alienated or be subject to any type of garnishment, levy, or other legal or equitable process. Furthermore, ERISA §514(a) generally preempts state laws relating to employee benefit plans, including state garnishment, levy, or other attachment proceedings.
The ERISA rule allows plan trustees to avoid the situation of being compelled by a state court order to make a distribution to a creditor that would have the effect of disqualifying the entire plan.
As a technical matter, a participant does not have the authority to pledge "his" account as collateral; the account is owned by the plan, not the participant.
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Question:
What happens if a distribution to a participant exceeds the participant's vested balance in he plan?
Answer:
The correction for this type of error is to put the plan into the position it would have been in had the error not occurred. The plan administrator may certainly request the overpayment back from the terminated participant. The overpaid amount is due back to the plan and should be reflected as a receivable asset. Have the participant repay the distribution to the plan and amend his or her tax return. The 1099-R will also need to be corrected. This can be self corrected under Rev. Proc. 2008-50, and therefore does not require IRS notification. Keep detailed records, and make changes so that this error does not recur.
In a 2001 case, Primary CareNet of Texas v. Scott, a plan erroneously distributed $3,600 too much to a terminated participant. The participant refused to repay the overpayment so the plan sued the participant. The court ordered the participant to repay the excess payment and to reimburse the plan $6,700 in attorney fees
Question:
Are all ADP/ACP refunds taxable in the year in which they're distributed? Or is this only for Plans with Automatic Enrollment? Or??? I'm a little lost as to which plans this applies to.
Answer:
I think your confusion comes from unrealistic expectations. You expect the rules to make sense...
Effective for plan years beginning after 2007, the following applies to the distribution of excess (ADP/ACP test) contributions:
1. Distributions made to correct a failed ADP test are taxable in the year distributed.
2. Distributions made from an EACA (eligible automatic contribution arrangement) more than 6 months after the plan year incur the 10% excise tax under 4979.
3. Distributions from any other 401(k) plan that are made more than 2 1/2 months after the plan year incur the 10% excise tax under 4979.
4979(f) No Tax Where Excess Distributed Within Specified Period After Close of Year. -
4979(f)(1) In general. - No tax shall be imposed under this section on any excess contribution or excess aggregate contribution, as the case may be, to the extent such contribution (together with any income allocable thereto through the end of the plan year for which the contribution was made) is distributed (or, if forfeitable, is forfeited) before the close of the first 21/2 months (6 months in the case of an excess contribution or excess aggregate contribution to an eligible automatic contribution arrangement (as defined in section 414(w)(3))) of the following plan year.
4979(f)(2) Year of inclusion. - Any amount distributed as provided in paragraph (1) shall be treated as earned and received by the recipient in the recipient's taxable year in which such distributions were made.
Question:
Can't Refund ADP Failure Prior to Year End - Have you ever heard of companies doing ADP or ACP testing prior to the end of the year, and then refunding an approximate amount of money to HCEs so that the test does not fail at year end? Is this OK to do? If it is, do you need to take gains into consideration or not?
Answer:
Yes, I have heard of companies following this procedure, and no, it is not OK.
The first problem with this is that it violates Regulation Section 1.401(k)-2(b)(2)(v) of the 2004 final regulations (1.401(k)-1(f)(4) under the 1991 regs), corrective distributions must be made “within 12 months after the close of the plan year in which the excess contribution arose…” and “…a distribution of excess contributions must be in addition to any other distributions made during the year…”. The 1991 regs said that excess contributions can be distributed "only if the excess contributions" are distributed "after the close of the plan year". So, the first reason you can’t do this is because "we (the IRS) said so". However, in this case, there is some logic behind the IRS position: A 401(k) plan cannot allow the distribution of elective deferrals, except for some very specific situations. One of these is to correct a failed ADP test. The rules for calculating the corrective distribution for a failed ADP test are very specific. If distributions are made based on estimated or projected numbers, someone may receive more than the amount necessary to correct the failed test, calculated under Code Section 401(k)(8)(C). Since part of this corrective distribution would not be required under the code to correct the failed ADP test, it would be a violation of the distribution rules applicable to elective deferrals, and could therefore result in plan disqualification.
However, a plan could permit an HCE to stop making deferrals or to lower deferrals during the plan year, based on a projected ADP test. There is nothing in the Code or Regulations that would prohibit this, but the plan document would have to allow for it.
Final (2004) regulation:
§1.401(k)-2 ADP test.
(b) Correction of excess contributions-
(2) Corrections through distribution
(v) Distribution. Within 12 months after the close of the plan year in which the excess contribution arose, the plan must distribute to each HCE the excess contributions apportioned to such HCE under paragraph (b)(2)(iii) of this section and the allocable income. Except as otherwise provided in this paragraph (b)(2)(v) and paragraph (b)(4)(i) of this section, a distribution of excess contributions must be in addition to any other distributions made during the year and must be designated as a corrective distribution by the employer. In the event of a complete termination of the plan during the plan year in which an excess contribution arose, the corrective distribution must be made as soon as administratively feasible after the date of termination of the plan, but in no event later than 12 months after the date of termination. If the entire account balance of an HCE is distributed prior to when the plan makes a distribution of excess contributions in accordance with this paragraph (b)(2), the distribution is deemed to have been a corrective distribution of excess contributions (and income) to the extent that a corrective distribution would otherwise have been required.
Question:
Converting existing regular 401(k) accounts into Roth accounts - Is there any upcoming change to the previous statement, possibly for 2010?
Answer:
No. Because Roth 401(k) contributions must be designated irrevocably at the time of the cash or deferred election, pre-tax elective deferrals may not be converted to Roth contributions.
402A(c) Definitions and Rules Relating to Designated Roth Contributions. - For purposes of this section -
402A(c)(1) Designated roth contribution. - The term “designated Roth contribution” means any elective deferral which -
402A(c)(1)(A) is excludable from gross income of an employee without regard to this section, and
402A(c)(1)(B) the employee designates (at such time and in such manner as the Secretary may prescribe) as not being so excludable.
§1.401(k)-1. Certain cash or deferred arrangements
(f) Special rules for designated Roth contributions
(1) In general. - The term designated Roth contribution means an elective contribution under a qualified cash or deferred arrangement that, to the extent permitted under the plan, is -
(i) Designated irrevocably by the employee at the time of the cash or deferred election as a designated Roth contribution that is being made in lieu of all or a portion of the pre-tax elective contributions the employee is otherwise eligible to make under the plan;
(ii) Treated by the employer as not excludible from the employee's gross income (in accordance with paragraph (f)(2) of this section);
(iii) Maintained by the plan in a separate account (in accordance with paragraph (f)(3) of this section).
Question:
Bank offering incentives for plan business - A client just told us that they have chosen to move their 401(k) plan to their bank because the bank would reduce the interest rate on the corporate loans in return for moving the investments to the bank. Can they do that?
Answer:
If the plan sponsor moved the investments and or administration to the bank in return for return for lower interest rates on its loans, they have engaged in a prohibited transaction. This transaction comes under the prohibition against using plan assets for the benefit of a party in interest. The party in interest in this case is the company. In this situation, the company is benefiting by making the decision to place plan assets with the bank. The prohibited transaction rules do not say that the transaction must result in a loss to the plan, the rules merely say that the party in interest must benefit. Here, the company is clearly benefiting.
To put this situation in perspective, when banks wanted to offer toasters as an incentive to set up IRAs, they needed a prohibited transaction class exemption. Prohibited Transaction Class Exemption 93-33 permits the receipt of services at reduced or no cost by an individual for whose benefit an IRA or Keogh (if self-employed) plan is established or maintained from a bank, provided the conditions of the exemption are met. However, PTE 93-33 does not apply to qualified plans, and it does not apply to reduced rate loans made to the plan sponsor. What is particularly noteworthy about this, however, is that, without this exemption it would be a prohibited transaction for an individual to place his or her IRA with a bank, if that individual received anything of value or any reduced fee service from the bank. This is true, even if the reduced rate service is provided by the bank for other account holders. If it took a specific prohibited transaction exemption to allow individuals to take advantage of a reduced fee service, using only their own money, it is clear that it would be a prohibited transaction for a plan fiduciary or other party in interest to do this with plan assets that include participants' money.
ERISA Section 406(a)states that a plan fiduciary may not cause a plan to engage in any transaction which he or she knows, or should know, constitutes a direct or indirect:
1. sale, exchange, or lease of any property between the plan and a party in interest;
2. loan of money or other extension of credit between the plan and a party in interest;
3. furnishing of goods, services, or facilities between the plan and a party in interest;
4. transfer of any plan assets to, or use by or for the benefit of, a party in interest;
5. acquisition, on behalf of any plan, of any employer security or employer real property in violation of the 10-percent limitation imposed by ERISA on the acquisition and holding of employer securities and employer real property.
Both the plan sponsor and the bank have violated #4.