Excess after-tax contributions to a traditional 401(k) - An unusual situation

[River_Rise]

Hello,

I'd be very grateful for any information on how to appropriately resolve the following issue.

In 2021, I made after-tax unmatched contributions to my traditional 401(k), and in the same year, rolled over the contributions and earnings to a Roth and Traditional IRA, respectively (the "mega backdoor Roth" strategy).

In 2022, I learned that due to an error by the 401(k) administrator, the 2021 after-tax contributions exceeded the plan limit (not the IRS limit). The 401(k) administrator requested that I send the funds back to them to be reprocessed for tax purposes. As a result, I recently completed "withdrawal of excess IRA contributions" processes for the Roth and Traditional IRAs to reclaim the funds at their current value (there were losses since the rollover). I sent a check back to the 401(k) administrator for the full value of the after-tax contributions and the earnings at the time of the rollover. I believe they should be sending me back the full amount of the after-tax contributions and treating the earnings prior to rollover as taxable income. 

My questions are as follows:

• Do I need to amend my 2021 tax return to include the earnings on the excess 2021 after-tax contributions as taxable income, or would they be reported in 2022?
• Are there any penalties applicable to this situation? Specifically, do I have to pay a penalty on the earnings from the excess after-tax contributions while they were in the 401(k)? There should be no penalties associated with the actual after-tax contributions, right?
• Lastly - are the following assumptions regarding the IRA rollovers correct? Having removed the excess IRA contributions before 10/17/22, I'll avoid the 6% penalty. With no earnings on those funds since the rollover, I also avoid the 10% penalty on earnings. As a result of no taxable events or penalties in this situation, this wouldn't require an amended 2021 tax return. 

Thanks in advance for any information!

[tagteam]

@dmertz ?

[dmertz · Accepted solution]

As I understand it, the after-tax portion was rolled over to a Roth IRA, the earnings on the after-tax funds while in the 401(k) were rolled over to a traditional IRA and there were no gains (or perhaps there was a loss) on the funds while in the traditional and Roth IRAs.

I think that the employer will only pay to you the amount of the after-tax contribution reclaimed, not the attributable gains, so the gains will be taxable to the employer, not to you.  You'll need to verify that with your employer.

Assuming that you timely filed your 2021 tax return, you are correct that removing the excess contributions by 10/17/2022 avoids the 6% excess-contribution penalty for 2021.  There is probably no reason to amend your 2021 tax return which would do nothing more than provide an explanation of what happened.  Just be sure to retain sufficient records to be able to provide explanation to the IRS if they question the returns of contributions.  If they ask for an explanation, the explanation will need to mention that the returns of contributions were obtained pursuant to section 301.9100-2 to indicate that you timely filed your 2021 tax return and that you received the corrective distribution by 10/17/2022.

[River_Rise]

Thank you very much for the reply - I really appreciate it. May I ask for clarification around the earnings on the after-tax contributions? If I understand correctly, you're saying those earnings are essentially forfeited to my (former) employer. That seems strange to me. Why would the employer be entitled to keep the earnings in this case? 

[dmertz]

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.

[River_Rise]

Thank you very much! I appreciate the information!