HCE Excess Deferral 2020 Rolled Over to IRA Corrected in 2021

[Driley73]

What Happened:

• During January through April 2020, and for several years prior, I was employed by XXX (as an employee), performing contract work for Collins Aerospace, 
• While employed at XXX, I contributed to a 401K maintained by Voya.  In those first few months of 2020 I was able to contribute what I thought was the maximum allowable to the 401K, approximately $24K (including catch-up allowance).
• After I left XXX, I transferred all of my savings from the Voya 401K to my rollover IRA account at Fidelity.
• Everything appeared to be fine when we filed our 2020 tax return in 2021.
• On December 2, 2021 I received an email from XXX stating...
• I need to let you know about some results of XXX’s 2020 401K plan testing and audit.  All 401K plans go through annual testing to ensure compliance with ERISA laws that govern how certain retirement plans must be administered.  One of the specific tests that takes place is ensuring that all employee classes are contributing to a plan in an equal manner.  Unfortunately, due to the nature of our plan and workforce we have failed a specific test that affects you individually.  Do not worry, this is not something you have done or could have expected to foresee.  The specific test failed is the ADP (Actual Deferral Percentage) test which tests to make sure that the contributions made by non-highly compensated employees (NHCEs) are proportional to contributions by owners, managers or highly compensated employees (HCEs).  Because you were classified as a Highly Compensated Employee (HCE) you have some excess contributions that cannot be applied to your 401K account as a result of this test failing.  This amount will be returned to you by Voya within the next few weeks.
• However, as noted above, Voya did not have any money to return to me. 
• After several emails back and forth, I learned that Voya was still required to document the excess contribution and that I had to pursue withdrawing the excess from my Fidelity rollover IRA.
• I contacted Fidelity, explained the situation, and filled out a special form that they have for these occurrences.
• I contacted Fidelity again later in December to resolve some issues with the form and got them to expedite the withdrawal.
• I felt that time was of the essence because it appeared that if I left the money there, additional penalties would be incurred.
• On December 28, 2021, Fidelity issued the withdrawal for me and also withheld federal and state taxes per my instructions.
• This withdrawal of approximately $12K was reflected in the total withdrawals for 2021 ($72K) on the 1099-R that I received from Fidelity in January 2021.
• In January 2021 Voya also sent me a corrected  2020 1099-R for the same withdrawal amount, showing no taxes withheld.  They also issued a revised total withdrawal 2020 1099-R that was reduced by the same amount.
• Note that Voya did not have any funds to distribute at that time.
• So far, in preparing our tax return for 2021, I have included the $12K distribution by Fidelity in our calculations, as it was simply included in the total 1099-R that they sent me.
• When Fidelity issued this special distribution in December, they sent me an email stating that I would have to fill out a form 5329 and that I might also have to amend our 2020 tax return.  Voya, in their parting letter on the subject, also mentioned a potential need for a revised 2020 return.
• We use Turbotax to prepare our returns, and I have found the 5329 form there, but I have questions.

Questions:

• Should the 5329 be submitted for the 2020 tax year, the 2021 tax year, or both?
• Which section of the 5329 applies?  Is it Part III - Additional Tax on Excess Contributions to Traditional IRAs?  There does not appear to be a section that applies to 401Ks
• If I must fill out the form for 2020, I assume that I will have to also submit a revised 2020 return.  Is that correct?
• If I must submit the revised 2020 return and a 2020 5329, will I be charged twice for the taxes on the $12K withdrawal?  ...once for the revised Voya 1099-R for 2020 that showed no withholding, and again on our 2021 return where the 1099-R from Fidelity included the actual withdrawal?
• I understand the need to pay taxes on the amount, but I don't believe I should be charged for that in both 2020 and 2021.
• Will I be subject to a 6% penalty because this excess amount was in my account for much of 2020 and 2021?
• Is there anything else that I need to know or any other actions that I need to take?

[dmertz]

The $12k that was an excess contribution to the 401(k) for 2020 due to the failure of ADP or ACP testing retroactively became an excess contribution to the traditional IRA when it was rolled over to the traditional IRA.  Because the corrective distribution of the $12k occurred after the due date of your 2020 tax return, including extensions, you are subject to a 6% excess contribution penalty for 2020 on this excess contribution.  If you haven't already filed a 2020 Form 5329 Part III reporting this excess contribution, you'll need to do so.  Also because it was done after the due date of your 2020 tax return, including extensions, the corrective distribution consisted of a regular distribution of exactly the amount of the excess with no adjustment for investment gains or losses.  This distribution eliminates the excess for 2021 and beyond.

The $12k is taxable on your 2020 tax return.

For entry of the $72k Form 1099-R into 2021 TurboTax, you'll need to split the Form 1099-R into two, one for the distribution of the $12k and the other for the distribution of the other $60k.  On the one with the $12k in box 1, enter a zero in box 2a  This will cause TurboTax to treat it as a nontaxable distribution of the excess and will prompt you to prepare an explanation as to why this portion is nontaxable.  You'll also need to visit the traditional IRA contribution section of TurboTax under Deductions & Credits and indicate that you had a $12k excess carried in from 2020 and indicate that you had $12k of excess distributed after the due date of your 2020 tax return.  TurboTax will include this amount on line 12 of your 2021 Form 5329.   On the split form with the $60k in box 1, enter $60k in box 2a.

[Driley73]

@dmertz Thanks for this information. I have a few clarifying questions...  Since I need to file a 2020 5329 form, I assume that also means that I need to file an amended return for that year, correct?  In order to do that, do I start by finding the 2020 5329 form in Turbotax, or do I start with the return itself and change something within it to cause the 5329 to be invoked?  Finally, how do I "split" the 2021 1099-R from Fidelity? Is there actually a button for that somewhere, or do I just change the existing one that I had entered, decreasing it by $12K, then add another 1099-R somehow?

Sucks that I now have to pay a penalty for the previous employer's screw-up.

Thanks again.

[dmertz]

Yes, you'll need to include Form 1040-X to correct your 2020 tax return to include the $12k as income.

Now that I think about it some more, if you made no intentional regular traditional IRA contribution for 2020 (or at least less than the limit), only the portion that exceeded the amount that you were eligible to contribute for 2020 was an excess traditional IRA contribution.  That may alter the split of the $72k.  You'll add the $12k to whatever regular intentional traditional IRA contribution you made for 2020 and 2020 TurboTax will calculate the actual amount that was excess.  (You'll probably end up with the permissible amount being a nondeductible traditional IRA contribution, but it will reduce the amount that is subject to the 6% excess-contribution penalty on your 2020 Form 5329.  However, it may be a bit of a nuisance to have to deal with basis in nondeductible traditional IRA contributions until you no longer have any money in traditional IRAs.)  It's this actual amount of excess that you'll report on the split 2021 Form 1099-R in 2021 TurboTax.

To split the 2021 Form 1099-R, you'll enter two Forms 1099-R that are identical except for the amounts in boxes 1 and 2a as I described previously.

Yes, it would have been better if the employer caught the problem a bit earlier in the year so that the distribution could be made before the due date of your 2020 tax return, including extensions.

[Driley73]

@dmertz  The $12K went into my rollover IRA, not my traditional IRA account.  I actually had zero contribution in the traditional IRA in 2020 and, so far, also zero into the traditional IRA for 2021.  So is my rollover IRA classified as a traditional IRA for tax purposes? ...because the 5329 form (2021 - haven't looked at 2020 yet) has nothing for either a rollover IRA or for a 401K.

As an aside, I already have an excess contribution in my traditional IRA from a prior year, when I mistakenly believed a broker who told me that it was OK to do that, even though I was contributing to a 401K.  He neglected to note that there was an upper income limit for my wife and I that negated that capability.

Again, thanks for your help. 

[dmertz]

A rollover IRA is a traditional IRA.  The tax code does not distinguish between IRAs that receive regular contributions and IRAs that receive rollover contributions.  The only thing that is unique to a particular account is the calculation of earnings attributable to a contribution being returned before the due date of the tax return, but that's not relevant in this case.

It seems that the contribution they you had made to your traditional IRA is not an excess contribution but was simply a nondeductible contribution.