Overwhelmed by overpayments

Compliance in defined contribution (DC) retirement plans can sometimes feel like the sword of Damocles is hanging over your head. On one hand, distributions requested by participants need to be processed on time. On the other hand, a distribution processed too quickly can result in errors. Fear not, the IRS recognizes that plans are bound to have distribution errors occasionally and has designated a section of the Employee Plan Compliance Resolution System (EPCRS) to discuss corrections in regard to erroneous plan payments. The IRS refers to these payments as “overpayments.”

An overpayment is an asset distributed to an individual before the participant is eligible to receive the funds. It is important to note they are funds that were supposed to be in a participant’s account (or forfeiture account) but were not yet eligible for distribution. Based on the terms of the plan document or IRS regulations, these funds are required to remain in the plan until a distributable event occurs. These are not dollars that were funded to the plan in error, rather legitimate sources of assets that were released prematurely.

Of course, the easiest way to fix a mistake is to prevent it from ever occurring. Some of the common ways overpayments occur, and areas to keep a watchful eye on, include:

1. Authorizing distributions that are not permitted in the plan document. A participant may meet the requirements for a distribution defined by the IRS or U.S. Department of Labor (DOL), such as hardship distributions, but the plan must allow for these types of distributions prior to participants taking advantage of them. Plan sponsors should monitor what distribution events are permitted per their plan documents.
2. Paying out participants’ employer contributions (such as match dollars or profit-sharing dollars) in excess of their vested amounts. This may happen if a match is paid out at 100% vesting but the participant was only entitled to 40% of the match dollars in their account. Administrators should be familiar with their vesting schedules and confirm that participants’ vested percentages look appropriate prior to authorizing a distribution.
3. Errors in census data can also create overpayment distributions. If a termination date is reported in error, it may result in the participant being allowed to request a distribution erroneously while still employed. If errors are discovered in reported hours of service, which can affect the vesting percentage, they should be corrected prior to distribution authorization.

Even the most cautious administrators aren’t perfect and processes and procedures to help guard against overpayments, sometimes fail. If that happens, the EPCRS has outlined what steps may be taken in order to self-correct the issue.

The most recent EPCRS guidance on overpayments is documented in Revenue Procedure (Rev. Proc.) 2021-30. Section 6.02 (f)(5)(c) defines allowances. If the overpayment is less than $250, no correction is required. A notice is not required to be provided to the participant and no adjustments need to be made. Although no formal correction is required, the overpayment distribution should be documented along with reference to this section of the revenue procedure as part of the correction. Think of a surprise health inspection in the kitchen. If a food inspector shows up and asks when a food item expires, you would want to have that documentation handy! It’s the same principle here. Although there is nothing wrong with doing nothing for an overpayment less than $250, you want to have documentation showing you took the proper action.

In a perfect world, plan sponsors never make mistakes because they follow the processes and procedures outlined above or they make the small error of overpaying under $250 so only documentation is necessary. But what about when overpayments occur and they exceed $250?

If the overpayment was caused by a distribution that is otherwise permissible in the Internal Revenue Code and Regulations but simply not allowed in the plan document, it is possible the plan sponsor can retroactively amend the plan document to allow for these types of distributions. Retroactive amendments can be done if the plan provided these distributions in a uniform and nondiscriminatory manner. The plan sponsor would have to have been following all the rules of hardship distributions as if the amendment had been in place. Again, documentation will be required to demonstrate what errors were located and that the amendment will be the correction.

What if the overpayment isn’t a broad sweeping error, and just select individuals were affected? Or perhaps it was a distribution that was not otherwise permissible under the code or regulations (such as an in-service distribution permitted prior to age 59-1/2)? In that case, section 2.04(1)(c) of Rev. Prov. 2021-30 indicates the correction is to return the overpayment to the plan. To do so, a notice is sent to the participant indicating that they received a distribution in error. The notice should include the dollar amount incorrectly distributed. Plan sponsors should also provide instructions to return the erroneous distribution. For most distributions, there could be unfavorable tax consequences if the dollars are not returned to the plan. The notice should warn participants of possible tax consequences and that their distribution tax form (Form 1099-R) may be adjusted to reflect this if the dollars are not returned. These notices should be sent via certified mail so that, in the event of an audit, there is proof that participants were notified of the error and the plan sponsor attempted to collect the erroneous distribution amount.

What happens if the participant ignores the notice indicating the distribution should be repaid to the plan? Should the plan sponsor send another letter? Maybe. Unfortunately, there is no hard and fast rule as to how many times a plan sponsor should contact a participant. The general rule of thumb is to use your best judgment. If it’s a very small payment you are attempting to reclaim, that would certainly affect the number of times a participant should be contacted. For very large distributions, it would not be uncommon to send several letters, as well as placing and documenting phone calls to the participant.

What happens if all attempts to contact the participant have failed or, worse yet, the participant has indicated they no longer have the money and cannot repay the overpayment? Is the employer on the hook? It depends. If the money otherwise belonged to the participant (think of salary deferrals that were withheld from a participant’s pay), no further action needs to be taken other than the attempt to reclaim. If the money had not otherwise belonged to the participant (such as unvested match dollars that were distributed in error) these funds would need to be recontributed to the plan plus earnings based on the plan’s rate of return. In this case, if the participant does not return the dollars, the plan sponsor is responsible for making the plan whole. In either case, documentation should be kept detailing the overpayment amount and the attempts made to reclaim the assets.

Is there a common theme here with the correction options? YES—documentation! No matter which scenario may fit your plan, the general principles of EPCRS self-correction require that documentation be made indicating what the error was and how it was resolved. In addition, you should include how your procedures will be modified going forward to ensure the error will no longer occur in the plan.

Although EPCRS is a lengthy and comprehensive tool to help guide you through the correction principles, not every situation will always be addressed. In those cases, it may be wise to submit through the Voluntary Correction Program (VCP) for full assurance on how a proposed correction method would be received by the IRS. Has your plan had an overpayment? Your Milliman service team or a Milliman compliance consultant will be able to assist you in preparing self-correction documentation or discuss the need for the VCP.

https://www.irs.gov/pub/irs-drop/rp-21-30.pdf