Addressing Mistakes in Tax Treatment of Employee Deferrals

An updated IRS web page tells retirement plan sponsors how to correct the mistake of using the wrong tax treatment of employee plan deferrals.

The Internal Revenue Service (IRS) says a common mistake it has encountered when employers have a Roth feature in their 401(k), 403(b) or governmental 457(b) plans, is that the employer does not follow the employee’s election as to whether deferrals are pre-tax or after-tax. 

In an updated web page on the IRS’ website, the agency says to fix the mistake of not following an employee’s election to designate the contribution as a Roth contribution the plan sponsor must transfer the deferrals, adjusted for earnings, from the pre-tax account to the Roth account. 

There are two options for reporting this transfer:

  • The employer issues a corrected Form W-2 and the employee must file an amended Form 1040 for the year of the failure.
  • The employer includes the amount transferred from the pre-tax to the Roth account in the employee’s compensation in the year it’s transferred. If the employer elects, it may compensate the employee for the additional amount he or she owes in income tax. This amount must also be included in the employee’s income.

If an employee makes an election to defer salary to the plan on a pre-tax basis, but the employer treats the deferral as a Roth deferral, it can transfer the erroneously deposited deferrals, adjusted for earnings, from the Roth account to the pre-tax account. The employer would file a corrected W-2 and the employee would file an amended 1040 for the year of the failure. 

The IRS says plan sponsors can use the agency’s Voluntary Correction Program (VCP) (if the error is significant and it meets the other conditions of voluntary correction). The error can be self-corrected, without IRS approval, if the mistake is insignificant or, if significant, if the plan sponsor corrects the mistake within two years. A plan sponsor can use self-correction only if the plan has practices and procedures in place designed to promote overall tax law compliance.