Sometimes retirement plans make payments to workers by mistake. Must they recover the money? What’s the worker to do? What if they roll the money to another account?
The Internal Revenue Service has released question and answer guidance on how to handle these inadvertent benefit overpayments.
The interim guidance addresses sections of the IRS code as added by Division T of the Secure 2.0 Act of 2022. IRS and Treasury are asking for feedback by Dec. 16 on the guidance, which is intended to help taxpayers.
The guidance applies to qualified defined benefit as well as qualified defined contribution plans, including 401(k) plans.
The Secure 2.0 provision “makes clear that an overpayment is eligible for rollover in most circumstances,” according to Michael Hadley, partner at Davis and Harman LLP. “For example, a 401(k) plan accidentally made a distribution to someone when they weren’t yet eligible, but was the correct amount from their account.”
Secure 2.0 “confirms that this distribution is still eligible for rollover to an IRA (if it would otherwise have been eligible for rollover, as not all distributions are),” Hadley said. “This IRS guidance is explaining this new rule in more detail, and explaining a few circumstances when the distribution would not be eligible for rollover.”
The Core Problem
“In our huge private pension system, mistakes will and do sometimes occur when 401(k)s, defined benefit plans, and other retirement programs make payments,” J. Mark Iwry, former head of national retirement policy during the Obama-Biden administration who’s now a nonresident senior fellow at the Brookings Institution in Washington, told ThinkAdvisor Thursday.
“The core problem is that ERISA’s fiduciary rules and the IRS correction programs required, or seemed to require, plans to recover any and all overpayments — to put the plan in the position it would have been in had the overpayment never occurred,” Iwry continued. “This often meant making innocent recipients repay the entire excess with interest, even if they had already spent it or had come to rely on the larger amount without realizing that it was incorrect.”
Many plan sponsors, Iwry continued, “felt reluctant to pursue recovery of inadvertent overpayments from innocent widows, orphans, or lower or moderate income individuals who had not been responsible for or even aware that they had been overpaid.”
Added Iwry: “If an overpayment was deliberate, as in some rare cases where business owners might have paid themselves more than the maximum legal limits permit, the relief does not apply. The relief applies to inadvertent payments which generally are still within the maximum legal benefit limits for qualified plans.”
Secure 2.0 and the IRS allow “plans to refrain from going after innocent retirees who received too much,” Iwry said.
The guidance also explains “employer option to repay the plan for the excess amount without collecting it from the participant,” Iwry said.
“If employer overpaid payments in a stream of monthly income (like an annuity), it can reduce the future payments by up to 10% to recover the excess on past payments,” Iwry said. “The limit reflects concern that innocent payees might have gotten accustomed to the larger amount.”
Defined benefit plans “have some special variants on the rules because [an] employer has funding obligations to a DB that might automatically increase, thereby preventing the remaining participants from being short-changed because earlier retirees got too much,” Iwry added.
“The various forms of relief apply only if the error was inadvertent so the payee was innocent.”
Corrective Payments
A participant or beneficiary “may make corrective payments in a lump sum, in installments, or, with regard to overpayments involving periodic payments, through reductions in future payments,” according to the guidance.
“If a plan sponsor chooses not to seek recoupment from a participant or beneficiary (or is unsuccessful in obtaining full recoupment), the plan sponsor or another person generally must make the corrective payments to the extent the full overpayment amount is not repaid to the plan,” the guidance states.
Further, if an overpayment is not corrected by plan amendment, “the plan sponsor generally must notify the participant or beneficiary in writing that the overpayment is not eligible for the favorable tax treatment accorded to distributions from an eligible retirement plan and is not eligible for tax-free rollover.”
Tax-Favored Status
For instance, one question addresses the circumstances under which an individual who rolls over an inadvertent benefit overpayment to an eligible retirement plan can retain the overpayment in tax-favored status.
The IRS explains that “under section 402(c)(12)(A), the portion of a rolled-over inadvertent benefit overpayment for which recoupment is not sought is treated as an eligible rollover distribution if the payment would have been an eligible rollover distribution but for being an overpayment.”
Accordingly, the IRS continues, “… an individual who receives an inadvertent benefit overpayment and rolls over that overpayment pursuant to a direct or 60-day rollover retains the tax-favored status of the overpayment for the portion of the overpayment for which recoupment is not sought.”
Further, “if an inadvertent benefit payment is rolled over from an originating plan to a second plan and recoupment of all or a portion of the inadvertent benefit payment is sought, then the amount that is sought and transferred back to the originating plan is treated both as an eligible rollover distribution from the originating plan and as an eligible rollover distribution transferred back to the originating plan,” the IRS explained.