Is severance eligible for 401k pre-tax deductions?

[TaxMan29]

Hi,   I received severance 3 weeks after my last day of employment. The severance was equal to several weeks of pay, and was separate then my last pay check and unused PTO.  My employer automatically deducted a percent of the severance to the 401k plan.  Months later this employer is saying that the severance was not eligible for 401k contributions after I have already rolled the 401k to an IRA. They are asking me to send them back a check of the value of the contribution and they will then pay me a direct deposit.   1) Is the severance pay not eligible for 401k pre-tax deductions?  2) Is there a way to not be penalized by the IRS for taking money that is now in my IRA and sending it back to the employer for them to try to fix the issue?

[Mike9241]

Severance pay would be considered compensation for a 401(k) plan under these circumstances:

1) It constitutes either normal wages or wages above-and-beyond normal income, like overtime pay, a commission, or a bonus; and
2) It would have been paid to the employee if they hadn’t been laid off; and
3) The payment is made either within 2.5 months after termination or by the end of the plan year, whichever comes first.

it would seem the company is correct. you may want to contact a lawyer.  if it were me I would want the employer to pay any IRS penalties and interest

[Hal_Al]

Q.  Is there a way to not be penalized by the IRS for taking money that is now in my IRA and sending it back to the employer for them to try to fix the issue?

A. I think so. If the IRA custodian issues a 1099-R, you report it as a return of contributions, and not taxable income.  @dmertz may be able to provide more detail

[Opus 17]

Firstly, duplicate post, see add on user here.

https://ttlc.intuit.com/community/retirement/discussion/re-converting-severance-to-retirement-funds/...

Second, because severance is considered “earned income“, it is considered eligible for 401(k) contributions by the IRS. You will not face any federal income tax consequences for having the money deposited in your 401(k) or for rolling it over to an IRA.

It might have been against the employer's policy to contribute the severance to a 401(k), especially if there was a match.  But that's the employer's problem, not a federal tax problem.    It would not be a federal problem unless the employer broke the rules (such as by paying after 2.5 months) but even then, it's the employer's problem, not yours.

I don't understand what the employer wants you to do.  Maybe they deducted $1000 and matched $500.  They want you to pay them $1500, and they will then pay you the $1000 that would have been in your wages (because they want their match back).  There is no way for you to take the money out of the IRA without paying income tax plus a 10% early withdrawal penalty.  You could send them money from your regular checking account, there's no way for them to know where the money came from and they shouldn't care, either.

Here's the worst-case scenario that I can think of.  You send them money, they send you back less money.  They change your W-2 to remove the 401k contribution.  That means you pay income tax on that money, even though it is still in the IRA.  You also pay tax on all the IRA monies when you withdraw it, meaning this small part of your IRA gets taxed twice (just the amount from the severance).  Unless this is a huge amount of money, that may just be something you have to accept.  

Alternatively, I'm not entirely sure I would send any money back.  How much is it?  Probably too little for them to sue you.  Do you think you might work for them again, or is it a small enough industry that they can affect your future employment?  Unfortunately it's also probably too small an amount to hire an attorney to help you.  

[dmertz]

Right.  The amount that was impermissibly deposited into the 401(k) became an regular contribution to the IRA when the 401(k) was rolled over to the IRA and treated as such on your 2021 tax return which can be returned before the due date of your 2021 tax return, including extensions (October 15, 2022) as long as you timely filed your tax return or requested a filing extension.  That amount must also be reported as income on the 2021 tax return.  If the employer does not correct the W-2, you would report the excess 401(k) contribution as miscellaneous income.

[TaxMan29]

Thanks for the response! It sounds like the severance is eligible for pre-tax 401k contributions and that this is a company problem, not a tax problem for me.

To answer some of your questions. The severance was paid in 2022. I am unsure how they will show it on my w-2. It is probably too small amount for them to try to sue me. The company went under and is shutdown. The had a the 401k administrator contact me about it and asked for me to mail a check to them, but the admin company was unsure of what was actually going on.

I received the severance 3 weeks (end of Jan 2022) after my last day of employment (Jan 3, 2022). (Even though I signed the severance contract on my last day of employment, it took them 3 weeks to pay out). The severance was equal to several weeks of pay, and was separate than my last pay check and unused PTO.  This is compensation that I would have earned had the company not shutdown and had I not been laid off. However had I left earlier I would not have received it. 

I rolled over the 401k to an IRA in March, so we are approaching 3 months (or 60 days)

[dmertz]

Since an elective deferral from the severance was ineligible to be deferred to the 401(k), the amount impermissibly deposited into the 401(k) became an excess contribution to the IRA when the 401(k) was rolled over to the IRA.  You'll need to obtain a return of this excess contribution.

Since the employer is asking to be reimbursed, it seems that the employer made a matching contribution for the impermissible elective deferral.  Those funds would be part of the excess contribution to the IRA and will need to be returned to the employer.

[Ursela1944]

So to confirm - If I am laid off my severance lump sum is not subject to 401K contribution? In other words the company would not take out my normal 401K contribution % from the lump sum severance ?

[Mike9241]

Severance pay would be considered compensation for a 401(k) plan under these circumstances:

1) It constitutes either normal wages or wages above-and-beyond normal income, like overtime pay, a commission, or a bonus; and
2) It would have been paid to the employee if they hadn’t been laid off; and
3) The payment is made either within 2.5 months after termination or by the end of the plan year, whichever comes first.