A common feature in 401(k), 403(b), and 457 plans is the option for employees to designate all or a portion of their elective deferrals as post-tax Roth contributions. However, this option may increase the likelihood of administrative errors.

Pre-Tax versus Roth Contributions

The difference between pre-tax and Roth deferrals lies in the timing of taxation.

• Pre-tax deferrals are made from gross income before it is taxed. The funds are taxed when withdrawn during retirement.
• Roth deferrals, on the other hand, are made from net income, meaning the income has already been taxed. Roth funds are not taxed upon withdrawal (subject to certain conditions) to avoid double taxation.

Pre-tax contributions are considered the traditional method for retirement plan contributions. However, allowing participants the option to elect Roth deferrals is a growing trend. For participants who can choose between pre-tax and Roth contributions, or a combination of both, the deciding factor often depends on when they expect to be in a lower tax bracket: now or in retirement.

While giving participants the flexibility to choose between pre-tax and Roth contributions enhances their retirement savings options, it can also increase the chance of errors in administering deferral elections.

The Error

An error occurs when:

• An employee elects Roth, post-tax deferrals, but the contributions are instead made from pre-tax income.
• Conversely, an error also happens when an employee elects pre-tax deferrals, but contributions are made from after-tax dollars.

To correct this, the participant’s account must be adjusted to reflect what it would have been if the election had been properly implemented. Plan sponsors may use reasonable correction methods under EPCRS that restore the participant’s account to the appropriate position.

Current guidance is provided under Rev. Proc. 2021-30, which allows self-correction of many operational failures, including misapplied deferral elections, if proper practices are in place.

Possible Correction Methods

1. Transfer of Contribution (with earnings)
   The contribution (plus any earnings) is transferred to the correct account based on the participant’s original election. The employer will then issue a corrected W-2 for the year of the error, and the participant will need to file an amended tax return for that year.

2. For Deferrals Made from Pre-Tax Income (Converted to Roth)

   • Transfer the contribution (with earnings) to a Roth account. The employer will also make a gross-up payment to the participant to cover the resulting income tax.
   • Alternatively, the transfer (with earnings) to the Roth account can be included in the participant’s compensation for the year in which the transfer is made.

In either case, the correction should be clearly documented and must follow a method that aligns with the plan’s terms and reasonably compensates the participant. Plan sponsors should follow the principles of EPCRS by using a reasonable and consistently applied method that restores the participant’s intended tax treatment.

For Assistance with Roth Contribution Errors

If you need help correcting a Roth contribution error, contact Ekon Benefits at (314) 367-6555 or info@ekonbenefits.com.

Straight From the Source

IRS 401(k) Plan Fix-It Guide – Roth Deferral Errors: https://www.irs.gov/retirement-plans/fixing-common-mistakes-correcting-a-roth-contribution-failure

Rev. Proc. 2021-30 – Employee Plans Compliance Resolution System: https://www.irs.gov/pub/irs-drop/rp-21-30.pdf