Correcting Roth Deferrals Made as Pre-Tax Deferrals or Vice Versa

Author’s Note: Over the past month this question has been asked by at least a half a dozen advisors, so I thought it would be a good thing to resurrect an article that NTSA ran quite a few years ago.

The Question: What happens when a participant signs a salary reduction agreement to defer into a school district’s 403(b) plan as a designated Roth contribution and two years later the error is caught where all of that money went into a pre-tax elective deferral account under the plan. 

In one case, the advisor informed us that there were over 100 employees of a school district client where the participants elected to make a Roth 403(b) salary deferral. Unfortunately, they were all set up as regular pre-tax deferrals and no one caught this for six months. The TPA suggested the school should talk to the employees and have them change their election to pre-tax by re-executing the election. Is this an acceptable correction method?

Answer: Absolutely not!! (Note: the discussion/correction method below will apply to a 403(b) plan, a 401(k) plan and a governmental 457(b) plan.)

The correction method is to go back and follow the employee’s SRA election. The pre-tax deferrals (that should have been Roth deferrals) along with the earnings must be transferred from the pre-tax deferral account to the designated Roth account. Remember the payor is required to separately account for these two sources of monies since the reporting is different once the monies are rolled over to another plan; transferred to another employer plan; or a distribution is requested.

The employer will then report this transfer by either:

1. issuing a corrected Form W-2, and if applicable, the participant must amend their income tax return; or
2. including the amount transferred from the pre-tax to the Roth account in the employee’s compensation in the year transferred.

The employer may (if this was an employer error) compensate the employee for the additional amount that he or she owes in taxes and include that amount in the employee’s compensation as well.

What if the error was the reverse problem?

If the error was in the opposite direction– in other words the employee elected pre-tax deferrals and the deferrals were deposited as Roth deferrals. The correction method in this case would be to transfer the erroneously deposited deferrals along with the earnings from the designated Roth account to the pre-tax account. The employer would then file a corrected W-2 and the employee would file an amended tax return for the year of the failure.

Can either of these be self-corrected?

 

Yes. If the employer has practices and procedures in place, and if the error is insignificant (if the error is significant then it must be corrected within two years). Otherwise, the employer must submit under the IRS’ Voluntary Correction Program (VCP) in order to rely on the correction.

You can find a similar explanation of this on the IRS website here. 

Apparently, on audit, IRS has noticed this error to be common among deferral plans — 403(b), 401(k) and 457(b) plans. In one recent case that was under audit, and the IRS determined that it was an employer error, the IRS required the employer to pay a CPA to assist in filing amended returns for the employees involved. 

Susan D. Diehl QPA, CPC, ERPA, TGPC, BCF™ is President of PenServ Plan Services, Inc.

Opinions expressed are those of the author, and do not necessarily reflect the views of the NTSA or its members.