When advising an employee who is retiring, be zealous in making sure she receives everything--but not more--than she is entitled to!
Question: In Year 1, Company X has two employees who are retiring, A and B, both age 65. The plan administrator has a bad hangover, mixes up the two accounts, and pays A $125,000, which was the amount B was supposed to receive, and pays B $150,000, which was actually the amount of A's benefit. So A has received less than she was supposed to receive, while B got an overpayment. Nobody notices this mistake until Year 3, at which time the plan immediately notifies the two retirees and starts trying to straighten out the mess.
Everyone agrees there was no way the employees could have spotted this error, short of hiring a forensic accountant to scrutinize several years' worth of plan documents.
Which retiree has bigger problems, A or B?
Answer: That's easy--B is in big trouble, while A is on easy street.
A got less than she was entitled to. So for two years she thought she wasn't as well off as she actually was, and that of course is unfortunate. But to make up for it, she'll get a nice fat check for the difference. She can spend that or save it, and have some good laughs with her friends about the stupid mistake her former employer made.
B on the other hand has problems--big problems. Just on a psychological level, she is poorer than she thought she was, and so unlike A (who receives an unexpected windfall), B has to suddenly tighten her belt. Any spending or other financial commitments she made on the basis of this unrealistic belief are strictly her problem--she must repay all that money to the plan regardless.
A plan overpayment followed by a repayment also raises many tax questions. The answer to each question is, "you lose!"
Tax Question 1: Does B have to include the full $150,000 in her gross income for Year 1? After all, she was entitled to only $125,000, so why should she have to include in her income money she had no right to receive?
Answer: The full payment is includible in the employee's gross income. The Code section that decrees taxability of retirement plan distributions has no exception for mistaken payments.
Tax Question 2: When B received that $150,000 payment in Year 1, she rolled it all over to her IRA. Is the $150,000 in fact tax-free in Year 1 because of the rollover?
Answer: No. Rolling over a plan distribution normally does make the distribution not includible in income, but that only applies to "eligible rollover distributions." To be an eligible rollover distribution, the distribution must comprise benefits the individual is entitled to under the plan. Any other plan distribution is not eligible for rollover. So B's rollover in Year 1 did eliminate "includability" for the $125,000 portion of the distribution that she was rightfully entitled to under the plan, but the $25,000 mistaken distribution was not a plan benefit and was not eligible for rollover. So the $25,000 is still includible in income for Year 1. Since she in effect under-reported her gross income for Year 1 she will owe penalties for late payment of tax. By the way, it's a good thing she's over age 59 1/2; otherwise she'd also owe the 10% "premature distributions" penalty on that $25,000.
Tax Question 3: At the time of the distribution in Year 1, B had already made her maximum "regular" IRA contribution for Year 1, so the $25,000 rollover-that-didn't-qualify-as-a-rollover was actually an excess IRA contribution. B was not eligible to make a "regular" IRA contribution in Year 2, because she was fully retired. She did not take any distributions from the IRA in Years 1 or 2. Does B owe a penalty for the excess IRA contribution in Years 1 and 2? Is there any way to get the IRS to waive this?
Answer: B owes the 6% excess IRA contribution penalty ($1,500) for Years 1 and 2 on the $25,000 excess contribution (total penalty $3,000). Unlike with the penalty for failure to take a minimum distribution, there is no procedure for IRS waiver of the excess IRA contribution penalty. She does not owe the penalty for Year 3 because she withdrew the excess contribution fully by the end of Year 3.
Tax Question 4: Is the $25,000 IRA distribution taxable to B in Year 3? It seems like this distribution should be tax-free since she will be required to include the $25,000 in her income retroactively for Year 1.
Answer: Yes it is also taxable in Year 3! It is taxable the same as any other IRA distribution--that is to say, it is fully includible in gross income except to the extent it represents a return of the participant's aftertax "basis" in the account. Her $25,000 excess contribution to the IRA in Year 1 did create basis in the account, so she gets some credit for it when she computes how much of the Year 3 distribution is includible in her income. However, she can't offset her "basis" dollar for dollar against the distribution. The basis in her IRA is allocated pro rata between the amount distributed and the amount still in the account ("cream in the coffee rule"). So, for example, if the total IRA value on the applicable date is $250,000, of which $25,000 is her "aftertax contribution," 10% of the distribution would be deemed a tax-free return of basis.
Tax Question 5: Does she at least get a tax deduction for the $25,000 repayment she has to make to the plan?
Answer: Oh yes, of course! The IRS regards a repayment of overpaid benefits as a "loss incurred in the trade or business of being an employee," deductible as a miscellaneous itemized deduction under IRC § 165(a). Thus this would be deducted on Schedule A and would be subject to the 2% of AGI "floor."
Moral for planners: When advising an employee who is retiring, be zealous in making sure she receives everything she is entitled to. Be even more zealous in assuring she does not receive MORE than she is entitled to!
Where to read more: See IRS Chief Counsel Advice 2013-13025 (3/29/13), explaining these points in a similar situation to "B's" described above. See also Rev. Rul. 2002-84, 2002-2 C.B. 953, § 1341(a), and § 67(a), (b)(9). For more on what constitutes an "eligible rollover distribution," see ¶ 2.6.02 of the author's book Life and Death Planning for Retirement Benefits (Ataxplan Publications, 7th ed. 2011; http://www.ataxplan.com); regarding excess IRA contributions, see ¶ 2.1.08. For how an excess IRA contribution creates "basis" in the account, see PLR 2009-04029.
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