by: Ilene H. Ferenczy, Esq.

The SECURE 2.0 Act of 2022 (“S2.0”) provided new guidance for correction of overpayments made by plans in contravention of either the law or the plan terms.  The IRS issued Notice 2024-77 (the “Notice”) on October 15, 2024 (interesting timing!), which gives us a broader understanding of how plans should handle these failures.

Pre-S2.0 Overpayment Corrections

Historically, plan sponsors and practitioners could look to Revenue Procedure 2021-30 for the methods of correction for overpayments.  Rev. Proc. 2021-30 contains the rules and procedures for the Employee Plans Compliance Resolution System (“EPCRS”), the IRS cookbook for corrections of disqualifying failures.  Under EPCRS, when a plan paid out money in excess of what was due, it was generally required to take two steps:

1. Determine whether to request that the overpayment be repaid to the plan; and
2. If overpayment was not requested or received, notify the participant that the overpayment was not eligible for favorable tax treatment, most particularly a rollover to another plan or IRA.

The plan sponsor could also choose to amend the plan so that the overpayment was converted to the “correct” amount – for example, by increasing the participant’s contribution or benefit under the plan.  This type of correction is subject to other Internal Revenue Code (the “Code”) sections that might not permit the amendment, such as violations of nondiscrimination rules or the prohibition on decreasing accrued benefits of the other participants.  In the case of defined benefit plans, practitioners need to avoid amendments that would violate the minimum funding rules of Code section 436.

To the extent that the overpayment and the failure to recoup the amount paid adversely affected another participant – for example, if the overallocation in a defined contribution plan caused another participant to receive a lesser allocation than that to which they were entitled – the plan sponsor or “another person” needed to contribute enough to make the plan whole.  The “other person” was generally assumed to be a fiduciary or a service provider responsible for the failure.

EPCRS also provides special rules relating to overpayment corrections in defined benefit plans.  The funding exception correction method permitted a plan that was sufficiently funded based on the Adjusted Funding Target Attainment Percentage (“AFTAP”), even after the overpayment, to avoid recouping the payment from the participant or making a replacement contribution.  The contribution credit correction method permitted the plan to use a credit balance to offset the additional contribution needed to meet minimum funding standards in light of the overpayment.  [For more information on EPCRS overpayment rules, check out our earlier Flashpoint about the current EPCRS procedure.]

What S2.0 and Notice 2024-77 Provide About Correcting Overpayments

Section 301(b) of S2.0 added Code section 414(aa), which outlines overpayment correction rules that modify some of what was previously provided in EPCRS.  S2.0 also added Code section 402(c)(12), which modifies the eligible rollover distribution rules in relation to overpayments that are not recovered by the plan.  Finally, S2.0 added Employee Retirement Income Security Act of 1974 (“ERISA”) section 206(h), which includes language similar to the Code section 414(aa) changes, as well as protections for participants and beneficiaries.

The Notice clarifies some of the fine points of the new Code sections.  It does not purport to interpret or affect ERISA section 206(h), which is under the Department of Labor’s (“DOL”) jurisdiction.

In short, the S2.0 changes to the Code do two things.  First, they permit certain overpayments to remain uncorrected without adversely affecting either the qualification of the plan or the permissibility of the rollover by the participant of the overpaid amounts into another plan or IRA.  Second, they codify certain overpayment corrections previously permitted by EPCRS.

These overpayment rules apply to qualified plans, 403(b) plans, 403(a) annuity plans, and governmental plans, including governmental 457(b) plans.

Overpayments Eligible for Correction Under These Rules

The S2.0 changes, as clarified by the Notice, permit a plan to use the above rules to resolve “inadvertent benefit overpayments” (“IBOs”).

The Notice defines an IBO as an eligible inadvertent failure that occurs due to a payment made from a plan that either (i) exceeds the amount payable under the terms of the plan or the Code and regulations; or (ii) is made before a distribution is permitted under the terms of the plan.  “Eligible inadvertent failure” is language taken from the modifications to EPCRS under S2.0 Section 305 and IRS Notice 2023-43.  For more information about what constitutes an eligible inadvertent failure, see our earlier FlashPoint.

The Notice adds a critical exclusion to the IBO definition:  an IBO does not include an overpayment to someone who is a “disqualified person” under the prohibited transaction rules of Code section 4975(e)(2).  This includes (among others) fiduciaries, owners of the company and their family members (spouse, ancestor, lineal descendant, or spouse of lineal descendant), officers, directors, 10% shareholders or partners and sole proprietors, or HCEs who earn more than 10% of the total wages of the employer.  This means that the correction rules of section 414(aa) and the Notice are not available in regard to overpayments to these people, and the normal EPCRS rules apply.  Clearly, letting those in charge of the company keep and roll over their overpayments is not kosher.

Another exception to an IBO is an overpayment that 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 IBOs do not include overpayments that are in excess of the limitations under Code section 415, overpayments that cause a violation of the compensation limit under Code section 401(a)(17), and defined benefit distributions in violation of Code section 436.  Furthermore, payment of amounts pursuant to EPCRS to correct violations of other Code provisions, such as a return of deferrals in excess of the participant’s election or corrective distributions, are not IBOs and are not eligible rollover distributions under these rules.

What Correction of an IBO is Permitted Under These Rules?

First, Code section 414(aa) provides that the failure to secure repayment of the IBO will not cause the plan to be disqualified.

Second, the provision codifies the ability of the plan sponsor to amend the plan to increase allocations or benefits to the participant to turn the IBO into a proper benefit payment.  Such amendments cannot be discriminatory or cause the benefit or allocation to exceed the limits of Code section 415 or base these amounts on compensation in excess of the Code section 401(a)(17) limit, which are required to be enforced.

Notwithstanding these provisions, if the decision not to recoup the payment disadvantages another participant, the plan sponsor or another person must still make the plan whole.

Section 402(c)(12) adds another participant-friendly provision:  if the plan does not try to recoup all or part of the overpayment, the part that it does not seek to get back is considered under Code section 402(c)(12) to be an eligible rollover distribution.  This means that the overpayment can stay in the plan or IRA to which it was rolled over without any negative tax impact.

Example:  Margaret received a distribution of $10,000 from her former employer’s profit-sharing plan. The plan, pursuant to Margaret’s election, directly rolled over the full amount to Margaret’s IRA. The $10,000 included $8,000 of overpayment because the plan accidentally paid Margaret based on 100% vesting, when she was only 20% vested.  Had the plan properly paid her, she would have received only $2,000.

The plan administrator looks at the cost of trying to recoup the overpaid $8,000 and the hassle it would be to try to do so, and decides it would be better to just reimburse the plan and let Margaret keep the money.

Because the plan administrator chose not to try to recoup the money, it does not need to give any notice of the overpayment to Margaret.  The plan continues to be qualified.  In addition, Margaret’s rollover of the entire $10,000 is an eligible rollover distribution and she does not have to remove it from her IRA or pay any taxes or excise taxes on the overpayment.

Any portion of the overpayment that is not an IBO or that the plan seeks to recoup and is not repaid to the plan is not an eligible rollover distribution.  The plan must advise the participant that such amount is not entitled to favorable tax treatment, particularly the right to roll it over. Taxes and excise taxes may apply in relation to the rollover, particularly if it was paid to an IRA.  Had the employer sought to recoup part of the overpayment, only the portion it did not seek to recover would be an eligible rollover distribution.

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.  This avoids taxation or excise taxation to the participant.  Furthermore, the plans are deemed to have permitted the return of the overpayment and the redeposit to the originally distributing plan.  Thereby, both plans can take these actions without fear of disqualification.

Can the Plan Still Try to Get its Money Back?

Code section 414(aa) makes it clear that providing the option to the plan not to seek repayment does not mean that the plan cannot do so.  Notice 2024-77 refers back to EPCRS to outline the actions that may be taken to recoup the overpaid funds.  These include notifying the participant of the overpayment and asking for the money back.  (EPCRS outlines what must be included in the notice.)  The overpaid individual may pay back the funds in a single sum or in installment payments, or the plan can reduce future periodic distributions. However, installment repayment is not available if the recipient is a disqualified person or owner-employee.

If the participant is getting excess periodic distributions, the plan must first reduce future periodic payments to the correct amount. Then it may further reduce the payments, subject to certain limits, to recoup the overpayment.   [See EPCRS Appendix B, section 2.05]

As mentioned earlier, the Notice does not discuss related issues that arise under ERISA section 206(h).  However, beware that the practical steps that the plan may take to try to recoup an overpayment from a participant are limited by section 206(h) for plans that are subject to ERISA.  There are limits on what the plan can do to recover the funds from participants and how much money is permitted to be sought to be repaid.  For example, the plan cannot charge interest or additional amounts (such as collection fees) on the overpayment.  Again, see our earlier Flashpoint referenced above for the details.

ERISA also provides that an overpaid participant must be permitted to contest all or a part of the purported overpayment and recoupment under the plan’s claims procedure.  If the overpayment was rolled over, the distributing plan must advise the recipient plan of the dispute.  The recipient plan must then hold back the purported overpayment pending the resolution of the issue, and, if the resolution is in favor of the distributing plan, can return the overpayment to the plan.

When the Guidance is Effective

Notice 2024-77 is effective as of the date on which it is issued, October 15, 2024.  Prior to that, a good faith, reasonable interpretation of Code sections 414(aa) and 402(c) applies.  Actions of the plan that are coincidentally in line with the Notice are considered to be a good faith, reasonable interpretation of the law.

The Notice further provides that plan sponsors and fiduciaries can rely on these rules in relation to determinations not to seek recovery of overpayments, their decision to permit installment repayments by overpaid participants, or their actions to reduce periodic payments in relation to the overpayments that occurred before S2.0 was passed and the Notice issued.  Furthermore, periodic payment reductions that commenced before December 29, 2022, can continue.

Does This Affect the Timing of the Revision of EPCRS?

S2.0 requires the IRS to modify the EPCRS procedures to take into account the new self-correction rules under S2.0 section 305 within two years of the law’s enactment, i.e., before December 29, 2024.

Nerds like us at FBLC have been waiting anxiously to see the new procedure (with a little trepidation, considering that the IRS issued important guidance last year right in the middle of the holidays).  We can’t help but wonder if this new guidance was issued because the new EPCRS procedure has been delayed.  While the Notice certainly addresses correction issues that have been up in the air since S2.0 was passed, we would still like to see complete guidance this year.

If you feel strongly about all or a part of the Notice contents, the IRS invites comments to be submitted on or before December 31, 2024.  Let your voice be heard!

Don’t Be Afraid to Let Us Know if You Have Questions

We know it’s Halloween time, but one thing that shouldn’t scare you is calling us with your questions.  After all, we are your ERISA solution!

And remember, with the release of this Notice and upcoming revised EPCRS, you can always stay current with the Corrections eSource on ERISApedia, written by Ilene, Derrin, and Alison.  For a deeper dive into this and other technical issues, plan on POPping on down to Atlanta April 24 – 25 for our Pensions on Peachtree conference.