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Refund of "excess" 401(k) contribution due to HCE tag

Client was just informed that she was deemed a highly compensated employee and the company was notified that it failed the test of its plan. She will receive a check for $12,000 of her $20,000 401(k) contribution for 2006 and a

1099-R. (For 2007, company will allow contributions of only 3% of salary, plus the $5,000 catch-up, rather than the $15,500 maximum allowed by the IRS.) Is my understanding correct that the 1099-R will specify this to be 2006 income? Will the 1099-R be received now or next year, since the refund is actually being received in 2007? Should her 2006 tax return (which has not yet been prepared) include the extra $12,000 or is preferable to wait until next year and file an amended 2006 return? Does it make a difference? Is there even an option? Are there pros and cons? I presume there are no penalties, even though she will now unexpectedly own aboutt $4,000 in Federal income taxes, plus another few hundred bucks to the State?
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Reply to
R. Pile
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Your understanding is correct.

The excess contribution, along with any income generated by that excess (which must also be distributed, as per Sec.

408(d)(4)), if distributed prior to the due date, with extensions, of the client's return for 2006 will constitute income to the client for 2006. There will be no excess contribution penalty. There should also be no penalty for underpayment of estimated tax since the plan is required to withhold on the distribution as if it were "wages."
Reply to
Shyster1040

Assuming they code it correctly, yes.

It will be a 2007 1099-R issued in January 2008. She will panic. You will tell her to turn it over and see what the box 7 code means. She will see that it's 2006 income that should have been reported on her 2006 return, and all will be well.

I certainly wouldn't sign a return I knew to be incorrect, which is what you'd be doing if you didn't include it when you file. Waiting until the 1099-R comes would also force her to pay interest when she files the amended return.

-- Phil Marti Clarksburg, MD

Reply to
Phil Marti

I recall that this is indeed one of those situations when a

1099-R will come in 2007 with a code of P indicating it is taxable in 2006. Since you know about it, I would report it and avoid having to amend and pay additional taxes plus possible penalties and interest. I believe it is taxed as ordinary income.
Reply to
Mike20878

Yes.

In 2008, with a code indicating it belongs on the 2006 return (maybe a P?)

Include it now.

Only if you consider doing it wrong to be an option. ;)

If she doesn't meet any of the other safe-harbors, she may well owe penalties. Phoebe :)

Reply to
Phoebe Roberts, EA

I typically get these after the fact and they are for $1-2K. Usually the partner I work for will just want us to pick it up in the current year since it's not a significant amount. For $12,000 it should definitely be picked up in the correct year.

Reply to
Mike20878

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