Return of a portion of the 401k corrective distribution

First some background:

1. For the tax year 2004, my company's 401k plan failed the non- discrimination test. A portion of my 401k contribution (since I was tagged as HCE) was refunded. Mass Mutual, the plan keeper ran the non- discrimination tests in early 2006 (no typo), 14-15 months after the plan year ended. So, all HCEs had to file amended tax returns for

2004.

1. For tax year 2005, they ran the non-discrimination test before April 15, 2006, and the plan passed. No impact on 2005 tax returns.

2. For tax year 2006, Mass Mutual ran the test around March 2007, in advance of the April 15, 2007 filing deadline. This time the plan failed in a BIG way -- almost 50% of the contribution was returned. I took care of this in 2006 tax returned, filed by April 15, 2007.

1. Fast forward to November 15th ... Mass Mutual informed our company that "[...] as a result of subsequent analysis, [...] a larger corrective distribution was made than was necessary". Basically, they goofed up the calculations, and the corrective distribution was about

25% larger than warranted. I think this, along with other poor service from Mass Mutual, could be one reason why the company is switching to Fidelity as the plan keeper starting in December.

I have now received a letter that says "[...] Under IRS Rules, the company is obligated to request return of the return of funds. However, participants are not obligated (not obligated underlined) to return the amount...." Further, "[...] if you elect to return excess portion of your corrective distribution to the plan, you will receive a corrected 1099R showing a smaller taxable distribution from the plan. This will require you to amend your 2006 tax return..."

So, tax pros and financial experts, and do-it-yourselfers, I am seeing your comments and suggestions.

1. Why is IRS being generous? Why am I not obligated to return the excess distribution?

1. It seems that by returning excess, I effectively increase my 401k contribution for 2006 (e.g., contributed max of 15K; after HCE excess distribution, was allowed to contriute only 8K, but after the return of excess distribution, it will be back to more like 10K). This will also reduce my taxes.

The downside is redoing both Federal and California taxes, a hassle. In prior years, I did my taxes with paper and pencil; last year I used TaxCut. How easy or difficult would it be to do amended returns with TaxCut? Worth $500?

Is it trrue that filing amended returns increases the DIF score, and increases chances for audit. I have only been audited once in 20 years, by mail, for not including AMT (6251), and it resulted in an extra few hundred, but I am (perhaps irrationally) afraid of ever being in audit, even at the cost of paying a bit extra taxes :)

My 2006 tax was unusual in that the family AGI, doubled for that year (extra bonus, all W-2 income, paid at the highest tax rate :(). But for 2007, I am back to the normal wage, about 10% higher than 2005, and half of 2006.

1. Has anyone else faced this? The math for the non-discrimination test seems simple enough ... I can't believe a large company like Mass Mutual messed up the calculations. (I can't do it myself, as it requires knowing the salary and 401 contribution of everyone in the company). I wonder how many other mistakes they make in record keeping...

Bhoot Nath