ARTICLE – OH, FINE! KEEP THE MONEY: THE NEW IRS OVERPAYMENT GUIDANCE

Publication: Journal of Pension Benefits

Date/Volume/Issue: Spring 2025, Vol. 32, No. 3

This column discusses the current correction methods for overpayment failures and the new guidance issued in Notice 2024-77 for such overpayments.

Plan Corrections
Oh, Fine—Keep the Money!: The New IRS Overpayment Guidance

By: Adrienne I. Moore, Esq.

With all of the money flowing into and out of a retirement plan and being divvied up among participants, it is not uncommon for too much money to be put into, and left in, someone’s plan account. The Employee Plans Compliance Resolution System (EPCRS) calls this an “excess amount.” [Revenue Procedure 2021-30 § 3.01(3)(a)] Excess amounts can occur where money was funded to a plan in excess of the limits set by Internal Revenue Code (Code) Section 402(g) or Section 415. They can also arise where amounts were funded in excess of the benefits provided by the plan. For example, if a participant’s incorrect compensation is used in calculating a nonelective contribution and the result is that the participant receives a greater allocation than if correct compensation had been used, the resulting nonelective contribution is an excess amount. Often these amounts will be corrected while the money is still in the plan, usually by forfeiting the excess amount and moving the money to the plan’s suspense account. If the excess amount is due to a salary deferral that is more than permitted, the excess would be distributed and reported as income. Once the money actually has been given to the participant as a distribution from the plan, however, the correction options change. The EPCRS overpayment rules cover any failure where a participant received a distribution of an excess amount from the plan, which could be an excess benefit inadvertently provided, as discussed above with incorrect allocations, or simply a mistake in which the participant gets paid more than is in their account or benefit, without a previous error. [Rev. Proc. 2021-30 § 2.01(3)(c)] Overpayments also cover any failure where the actual amount of the benefit was correct, but it was paid out to a participant earlier than permitted (for example, in the absence of a distributable event under the plan).

EPCRS, currently contained in Revenue Procedure 2021-30, has long provided the correction methods for overpayment failures. When the SECURE 2.0 Act of 2022 (SECURE 2.0) was passed, it added certain new correction options for overpayments. On October 15, 2024, the Internal Revenue Service (IRS) issued Notice 2024-77 (the Notice) to provide additional guidance on how the new correction options may be used. This is good news, as the IRS was supposed to provide an updated EPCRS by the end of 2024, which presumably would have included updates to the overpayment procedures. At time of writing, the new EPCRS remains unseen.

The Rules under EPCRS

In limited circumstances, some overpayments can be corrected by an amendment to the plan. [Rev. Proc. § 6.06(4)(a)] This most often will be useful in cases where contributions were incorrectly allocated or, in defined benefit plans, where the benefits were incorrectly calculated, and already have been paid out to a participant. For example, if a plan’s definition of compensation excluded bonuses, but in operation, the plan sponsor has always included bonuses in calculating contributions to the plan, the problem could be repaired by amending the plan to fix the definition of compensation. This would align the document to actual operations and resolve any excess amounts and overpayments related to the incorrect definition that was used. Remember that a correction carried out pursuant to EPCRS cannot cause the plan to violate any other Code section, regulations, or other guidance. Benefits distributed from a defined benefit plan in excess of a participant’s Code Section 415 limit, then, cannot be corrected by plan amendment.

Because the plan amendment approach has limited applicability, the more common correction is the return of overpayment method. [Rev. Proc. 2021-30 § 6.06(4)(c)] Under this method, the employer must take reasonable steps to have the overpayment repaid to the plan by the recipient. The returned funds must be adjusted for earnings at the plan’s earnings rate from the date of the distribution to the date of the correction (that is, the dates money is returned). The employer may permit the recipient to repay this in installments and specifically may permit the recipient to choose whether they will repay in one transaction or installments. The returned funds must then be placed in the plan’s unallocated account. [Rev. Proc. 2021-30§ 6.06(4)(d)] The money may then be used to reduce employer contributions or, if the amount would have been allocated to other eligible employees who were in the plan for the year of the failure if the failure had not occurred, the money is reallocated to the other eligible employees in accordance with the plan terms. If the actual amount distributed to the participant does not violate the Code or plan provisions, and the payment was simply issued to the participant in the absence of a distributable event under the plan, then any amount returned by the participant will be allocated back to their account in the plan, rather than the unallocated account. [Rev. Proc. 2021-30 § 6.06(4)(e)]

The rules above generally apply to all plans. Defined benefit plans have a few special options for correction under EPCRS. Overpayments can be corrected by plan amendment and a return of overpayment. [Rev. Proc. 2021-30 §§ 6.06(3)(a), 6.06(3) (c)] If a participant is receiving periodic payments of an inflated benefit, any future payments must be reduced to the corrected amount. [Rev. Proc. 2021-30 § 6.06(3)(b)(i)] Furthermore, future payments may be further reduced (with some limitations) to recoup the overpayment. [EPCRS Appendix B § 2.05(2)(b)]

Additionally, for defined benefit plans only, if the plan has a sufficient funded status or if contributions to the plan were increased as a result of the overpayment (as it, in all likelihood, created an overstatement of liabilities when preparing the valuations), repayment may not be required. If, at the time of correction, the plan’s certified or presumed Adjusted Funding Target Attainment Percentage (AFTAP) under Code Section 436 is equal to at least 100 percent, corrective payments are not required. [Rev. Proc. 2021-30 § 6.06(3)(d)(i); Appendix B § 2.05(3)] In the case of a multiemployer defined benefit plan, where AFTAP is not used, instead look to the plan’s most recent annual funding certification. If that reflects that the plan, on the date of correction, is not in critical, critical and declining, or endangered status, pursuant to Code Section 432, corrective payments are not required.

Finally, EPCRS provides the contribution credit correction method. This method acknowledges that, in paying out an excess benefit, the funds available in the plan to pay other participants’ benefits were reduced. Therefore, some amount of the minimum funding requirement in future years was increased as a result of the overpayment. With time, essentially, the minimum funding will catch up the plan to where it would have been absent the overpayment. Taking this into account, the amount of the participant’s repayment is reduced, potentially entirely, by the cumulative increase in the plan’s minimum funding requirement attributable to the overpayment. [Rev. Proc. 2021-30 § 6.06(3); Appendix B § 2.05(4)] Any amounts contributed to the plan after the date of overpayment that went beyond the minimum funding requirement also reduce any corrective repayment amount.

In general, EPCRS anticipated that the plan sponsor would contact the affected participant to seek repayment of the overpaid amount. If the participant refused to keep the money (or, more often, just ignored the plan sponsor’s efforts), someone (usually the plan sponsor) would make the plan whole and the participant would be notified that the money they received was not eligible for rollover. [Rev. Proc. 2021-30 §§ 6.06(3)(b)(ii), 6.06(4)(b)(ii)] The practical effect of this was that, if a participant had rolled over the money to another qualified plan, the sponsor of that plan, upon being notified of the excess rollover, would ensure distribution of the overage back to the distributing plan. If the excess amount was rolled over into an individual retirement account (IRA) instead, excise taxes under Code Section 4973 would apply on the excess as long as it was retained in the IRA. Under EPCRS, only small overpayments, defined as $250 or less, did not require the plan sponsor to seek repayment or to notify the participant that the payment was ineligible for rollover. [Rev. Proc. 2021-30 § 6.02(5)(c)]

Changes under SECURE 2.0

SECURE 2.0 added Code Section 414(aa), which provides for circumstances in which a plan will not become disqualified as a result of overpayment. Simultaneously, it added Code Section 402(c)(12). This section modifies the eligible rollover distribution rules as it relates to certain overpayments, allowing participants to keep the money in the recipient account. Finally, SECURE 2.0 added Section 206(h) to the Employee Retirement Income Security Act of 1974, as amended (ERISA). This language essentially adds the same protective language from the Code to ERISA to ensure consistent enforcement across the IRS and the Department of Labor (DOL). The Notice helps to flesh out the IRS’s approach to overpayments while we await the amended EPCRS.

The changes in SECURE 2.0 codified certain correction options for plan sponsors while also expanding the circumstances in which a plan sponsor would not be required to seek recoupment from an overpaid participant. Under Code Section 414(aa)(1)(a), a plan will not be disqualified “merely because” it is unable to obtain the return of an “inadvertent benefit overpayment.” Additionally, Code Section 402(c)(12) dictates that any overpayment that the plan sponsor does not seek to have repaid is treated as an eligible rollover distribution (making notice to the participant on eligible rollover status immaterial).

What Is an Inadvertent Benefit Overpayment?

The Notice requires that an inadvertent benefit overpayment be an “eligible inadvertent failure,” which is defined in Section 305(e) of SECURE 2.0. [Notice Q&A-1] Generally, an eligible inadvertent failure is one that occurs in spite of existing practices and procedures aimed at overall compliance. The inadvertent benefit overpayment must also be due to a payment made from a plan that either exceeds the amount payable under the terms of the plan or the Code and regulations, or is made before a distribution is permitted under the terms of the plan.

Interestingly, an inadvertent benefit overpayment does not include an overpayment to someone who is a “disqualified person” under Code Section 4975(e)(2). Disqualified persons include fiduciaries, owners of the company and their family members (spouse, ancestor, lineal descendant, or spouse of lineal descendant), officers, directors, 10 percent shareholders or partners and sole proprietors, or highly compensated employees who earn more than 10 percent of the total wages of the employer. This is more restrictive than many initially anticipated. For these individuals, the normal correction rules in EPCRS will apply, and repayment of the excess often will be required.

An overpayment is not an inadvertent benefit overpayment if it violates a provision of the Code other than the failure to follow the terms of the plan. Such a failure is subject to the normal EPCRS correction methods, generally requiring an attempt to recover the funds, and treatment of any rollover of the overpayment as impermissible. The Notice specifically provides that overpayments that violate the benefit limits of Code Section 415, overpayments of benefits based on compensation in excess of the compensation limit under Code Section 401(a)(17), and defined benefit distributions in violation of Code Section 436 cannot be inadvertent benefit overpayments. [Notice Q&A- 2, Q&A-5, and Q&A-6] These will continue to be corrected by the EPCRS rules. Moreover, payment to participants made pursuant to EPCRS to correct violations of other Code provisions are not inadvertent benefit overpayments. [Notice Q&A-1] As an example, if a participant deferred in excess of the Code Section 402(g) limit and that money was distributed to the participant, the amount distributed cannot simultaneously be an inadvertent benefit overpayment. Any such amounts are not eligible rollover distributions.

What Are the Correction Options and Plan Sponsor Obligations?

As discussed above, the new law often will permit a plan administrator to simply not seek repayment of the overpaid amounts. The correction is in determining that Code Section 414(aa) and the Notice apply, and that the overpayment may be deemed to be corrected (and not disqualifying) with no further action. In practice, then, plan administrators will want to document their analysis in a memorandum to ensure that, if the determination is called into question years down the line, they are able to justify why the overpayment qualified as an inadvertent benefit overpayment. Code Section 414(aa) also provides that the plan sponsor may amend the plan to increase allocations or benefits to the participant so that the inadvertent benefit overpayment will match the plan document, bringing the operations and document back into alignment. [Code § 414(aa)(1)(B)] Although this correction via amendment is permitted in EPCRS, the SECURE 2.0 change codifies this ability. Any corrective amendment cannot be discriminatory or cause the benefit or allocation to violate another provision of the Code. [Notice, Q&A-7] For example, a corrective amendment would not be valid if the increased benefits would exceed the limits of Code Section 415 or be calculated using compensation in excess of the Code Section 401(a)(17) limit. This is consistent with the general principles of EPCRS that a correction method should not cause the plan to violate another section of the Code or any parallel requirement of ERISA. [EPCRS § 6.02(2)(d)]

The law requires that the plan sponsor make contributions to the plan as needed to meet minimum funding standards or to prevent or restore an “impermissible forfeiture.” [Code 414(aa)(3)] The logical extension of this is that, if an earlier excess allocation (which has since turned into an overpayment) also resulted in another participant receiving less than they would have had the plan operated correctly, that participant must be made whole. For example, if a profit-sharing allocation from a prior year was based on impermissible compensation for one participant, the result is that the excess allocation to that participant also caused a short allocation to everyone else in the plan. If that excess allocation was later distributed, the plan sponsor will need to fund that difference to the plan and allocate it among the affected remaining participants in accordance with the plan terms, so that they are “made whole.”

When Should a Plan Sponsor Seek Repayment?

The benefit of these rules is that they allow a plan sponsor to approach an overpayment failure with consideration given to how much energy really should be expended to recapture money, particularly if it will not change the benefits for anyone else. For example, assume Judy received a distribution of $10,000 from her former employer’s plan and rolled this over to her IRA. At the time of distribution, Judy’s vested percentage was incorrectly calculated as 100 percent, when really, she was 80 percent vested. Therefore, Judy received an overpayment of $2,000. Judy is not a disqualified person. The costs for the plan administrator to attempt to recoup the overpayment, and the time and effort to do so, could easily eclipse $2,000. Based on this, the plan administrator decides not to seek recoupment. The plan is still qualified and Judy does not need to distribute any money from her IRA as a correction. Remember that excess contributions to an IRA typically are subject to a 6 percent excise tax for each taxable year in which the money remains in the IRA. [Code § 4973] Because the money may properly remain in the IRA under Code Sections 414(aa) and 402(c)(12), Judy will not owe any excise taxes on the overpayment.

On the other hand, for greater amounts, the plan administrator may determine it is prudent to seek repayment from the overpaid participant. In those cases, if the overpayment is not repaid, it is also not an eligible rollover distribution. The plan administrator will need to notify the participant that the overpayment amount is not entitled to favorable tax treatment, specifically that it is not eligible for rollover. Taxes and excise taxes may apply in relation to the rollover, particularly if it was paid to an IRA.

If the recipient plan or IRA returns the overpayment to the distributing plan, both the original rollover and the return of the funds are treated as eligible rollovers. [Notice 2024-77 Q&A-4] This avoids taxation or excise taxation to the participant. Additionally, the plans are deemed to have permitted the transactions and remain qualified.

A Note on ERISA

As was noted above, SECURE 2.0 added ERISA Section 206(h). Interpretation of ERISA remains with the DOL, whereas the Notice was published by the IRS. Any application of ERISA Section 206(h) is not addressed in the Notice. We will need to await further guidance from the DOL to have a full picture of overpayment treatment. It will be especially useful to have the DOL’s guidance as to how a plan fiduciary can best assess in which situations it is reasonable not to seek repayment.

Conclusion

The IRS’s updated rules for overpayments take a realistic approach at correction in permitting plan administrators to weigh the benefit to the plan and its participants in chasing (often former) employees for what may be miniscule balances. For years, plan sponsors have fruitlessly chased overpayments only to be ignored by the receiving participant. If the amounts were so small as to not be worth litigating, plan sponsors would simply make up the difference to the plan, notify the participant, and move on. In all likelihood, massive amounts of overpaid money remain in receiving plans and IRAs due to the inertia of overpaid employees. The simplified options and ability of a plan sponsor to simply let the money go is a welcome improvement.