My original thought on that is that the plan is an entity separate from you, so you are not the one who earned the income (gains) even though you are the one who directed the investment of that produced income and the money that produced the income ultimately is yours. On second thought, though, I wonder why they asked to have the funds returned to them. It seems like only excess employer matching contributions and attributable gains would need to be returned to the employer, but those aren't involved here. It seems like the plan should have just issued a corrected Forms 1099-R for the rollover showing the permissible amount of the rollover, if any, and show on Form(s) 1099-R the amount ineligible for rollover and the taxable attributable gains. Perhaps they will report it like this and just give the entire amount back to you. Again, ask the employer/plan.
