Correcting Roth Deferrals made as Pre-Tax Deferrals

Susan D. Diehl

Many employees of a school district client elected to make a Roth 403(b) salary deferral. Unfortunately, they were all set up as regular pre-tax deferrals and no one caught this for six months. The TPA is suggesting the school should talk to the employees and have them change their election to pre-tax. Is this an acceptable correction method?

Answer: Absolutely not!! (Note: the discussion/correction method below will apply to a 403(b) plan, a 401(k) plan and a governmental 457(b) plan.)

The correction method is to go back and follow the employee’s SRA election. The pre-tax deferrals (that should have been Roth deferrals) along with the earnings must be transferred from the pre-tax account to the Roth account. Remember the payor is required to separately account for these two sources of monies since the reporting is different once the monies are rolled over to another plan; or transferred to another employer plan.

The employer will then report this transfer by either:

1. issuing a corrected Form W-2, and if applicable, amending its income tax return; or
2. including the amount transferred from the pre-tax to the Roth account in the employee’s compensation in the year transferred.

The employer may (if this was an employer error) compensate the employee for the additional amount that he or she owes in taxes and include that amount in the employee’s compensation as well.

What if the error was the reverse problem?

If the error was in the opposite direction– in other words the employee elected pre-tax deferrals and the deferrals were deposited as Roth deferrals. The correction method in this case would be to transfer the erroneously deposited deferrals along with the earnings from the Roth to the pre-tax account. The employer would then file a corrected W-2 and the employee would file an amended tax return for the year of the failure.

Can either of these be self-corrected?

Yes. If the employer has practices and procedures in place, and if the error is insignificant (if the error is significant then it must be corrected within two years). Otherwise, the employer must submit under the IRS’ Voluntary Correction Program (VCP) in order to rely on the correction.

You can find a similar explanation of this on the IRS website here. 

Apparently on audit, IRS has noticed this error to be common among deferral plans — 403(b), 401(k) and 457(b) plans.

Susan D. Diehl, CPC, QPA, ERPA, is President, PenServ Plan Services, and Chair of the NTSA Communications Committee.

Opinions expressed are those of the author, and do not necessarily reflect the views of NTSA, or its members.