Solutions In A Flash – Retirement Plan Correction Solution:
Maybe She’s Lucky: Correcting Overpayments in Defined Contribution Plans after SECURE 2.0

by: Jessica M. Hobbs, Esq.

Britney, a retired singer and superstar, owns and operates Lucky Records, a record company in Los Angeles with 44 employees. The company sponsors the Lucky Records 401(k) Profit Sharing Plan (the “Plan”) to help its employees save for retirement. All employees are eligible to enter the Plan after completing one year of service. Britney’s HR department, headed by the HR VP (who decided last year to fire the TPA because he could do anything the TPA did), completes the Plan’s annual ADP testing. Unexpectedly, he finds that the test was failed because of the significant deferrals by its record executives—a group of Highly Compensated Employees (“HCEs”). In response, Lucky Records distributes refunds to the record executives to correct the testing failure and moves on to producing its next hit album.

Several months later, someone in the Lucky Benefits Department listened to a Ferenczy Benefits Law Center webcast on ADP Testing and learned about the “top-paid group” rule, under which some people thought to be HCEs due to the level of their compensation are actually NHCEs. That person checked the Plan and, sure enough, it provided for that rule. As a result, the re-testing was actually incorrect because several employees were reflected as HCEs when they should not have been. Much to Britney’s dismay, the Plan improperly and unnecessarily distributed refunds to the HCE executives.

Naturally, pandemonium ensues, and the Human Resources department transforms into what Britney can only describe as a circus. The refunds issued to executives are problematic and must somehow be addressed.

Britney isn’t sure what she should do but calls Justin, her former TPA. “Justin,” Britney starts, “I know it’s been a long time since we’ve talked, and I hope this isn’t toxic of me, but there’s a problem with my company’s retirement plan and I’m hoping you can help.” Justin, fearing his friend would start crying a river, is eager to help her and begins walking Britney through next steps.

Trouble For Me: The Issue with Overpayments

Britney doesn’t understand why they cannot just designate the refunds to HCEs as bonuses, write them off, and move forward. Justin explains that the Internal Revenue Service (the “IRS”) has specific language and procedures to correct plan errors and advises that the refunds distributed to HCEs earlier in the year are considered “overpayments,” that is, amounts paid to participants that should not have been.

Justin tells Britney that overpayments must be properly corrected, so as to avoid additional compliance and qualification issues. Justin takes a few minutes to ask Britney some questions to get a broader scope of the current situation. Who are the affected participants? What is the total overpayment (including earnings and losses)? Do the affected participants still have access to the money, or have they spent it? If they still have it, are they willing to return it to the Plan? Justin advises that the answers to these questions will guide the corrections process and potential recovery efforts.

In general, the IRS’s correction rules require the Plan to request that participants repay the overpayment.  (In situations not involving overpayments due to testing errors, there may be a need to amend Forms 1099R for the amounts distributed if the participant does not make the repayment.)  However, the SECURE 2.0 Act made fixing this problem easier if the overpayment is an “inadvertent benefit overpayment” or “IBO”.

IBOs are defined in IRS Notice 2024-77 (which interpreted Section 301 of the SECURE 2.0 Act) to be overpayments made by mistake, despite the plan having policies and procedures to help comply with the law. The Notice specifies that IBOs do not include overpayments to sole proprietors, more than 10% partners in partnerships, and “disqualified persons” under the prohibited transaction rules. Disqualified persons generally include 50% shareholders of the plan sponsor, fiduciaries, officers, directors, HCEs earning at least 10% of the annual wages paid by the plan sponsor, and service providers to the plan.  If the overpayment is made to any of these individuals, the normal overpayment correction mentioned above applies (i.e., the plan must ask for the money back).  In addition, a payment in excess of certain IRS limits cannot constitute an IBO.

Do Somethin’: What Does the Guidance Say?

Britney now understands what overpayments are and why the incorrect refunds to executives are problematic. Justin begins advising her on correction options. Justin advises that in some limited circumstances, usually in defined benefit plans, overpayment can be corrected with a retroactive plan amendment. Of course, this case involves a 401(k) plan. The second permissible correction is the one noted above: asking the participants to return the overpayment. However, Justin tells Britney that she is permitted, but not required, to simply let the overpaid participants keep the paid funds if the overpayment is an IBO (that is, if the overpaid individual is not part of the ineligible group of participants noted above).

There are times when an overpayment to one person means that someone else’s account has been harmed. If that were the case, the plan would need to be made whole either through participant repayment or a corrective deposit from the company. Fortunately, since the overpayment was made from the participants’ own deferral accounts, the overpayments affected no one else.

If Britney wants to, she can seek repayment of the IBO from the affected participant or beneficiary (and she must do so if the participant is a disqualified person). The repayment actions are subject to the following limitations:

1. Recovery may not be sought from a surviving spouse or beneficiary.
2. There can be no threats of litigation against a participant during the recovery process, unless it is reasonably likely that the amount recovered from the participant will be greater than the cost of recovery. Britney should use discretion here and consider whether litigation is necessary and worthwhile.
3. The overpayment may not be referred to a collection agency unless there is a final judgment or settlement that authorizes recovery that the participant rejects or ignores.
4. No interest or fees may be sought on the overpayment.
5. The overpayment must have occurred within three years of the participant or beneficiary being notified of the error in writing.
6. If the participant is receiving periodic payments from the plan (such as an annuity), the overpayment may be recouped from future payments, but there are limitations on how that works.

Justin identifies any of the overpaid HCEs who are owners in Lucky or who had compensation high enough to represent at least 10% of the prior year’s total compensation paid. Those people must be asked to repay their distributions. However, if they refuse to do so, no further action is needed by Lucky.

For those who do not fall into the “disqualified” category, Britney needs to take no further action.

Refunds and distributions due to testing failures are not eligible for rollover. Had the overpayment been made for another reason and categorized as an eligible rollover distribution, special rules would apply.

It Should Be Easy: Problem Solved?

Britney thanks Justin for his help, relieved that they were able to talk through the issue and potential next steps. Justin reminds Britney that she should also reach out to legal counsel to assist with the correction—in fact, he knows a great firm in Atlanta that can assist. And Justin reminds her that not using a TPA has its downsides: clearly the VP of HR is not the benefits guru he thinks he is!

Justin stands to leave, believing his work to be done, when Britney stops him. “Justin, there’s something I need to mention,” she starts. “You may recall that my company sponsors another plan, a pension plan, that used the same census data for testing nondiscrimination this year and may have had compensation errors in that plan, too. I guess you could say… we did it again.” Justin looks forward to the opportunity to assist Britney one more time.

Come back soon for Part II in the Lucky Records Saga to learn more about overpayments guidance related to defined benefit plans!

If you or a client need assistance correcting an overpayment issue like the one Britney and Lucky Records faced, please contact us about your correction options. After all, we are your ERISA solution!