Too much contribution to 401K

[question everything]

A friend of mine works for a small company. He is one of the higher paid manager and is 60 years old so has been contributing the maximum to 401K - this year $20,500.

It appears, however, that not enough lower paid employees contribute so he is going to get back something like $5,000 and was told that next year he will have to limit the amount of contributions.

He has several IRA accounts (one that used to be 401K from a former employer and was rolled over).

Would opening a Roth IRA make sense?

[A HERETIC I AM]

1. Sure.

The short answer is yes, a Roth makes perfect sense. Also, if he has, as you say, several IRA's, he might want to consider doing a conversion on one or more of them from the IRA to the Roth, IF there would be a long term tax advantage to doing so. In order to find this out, he would need to do some calculations to see if there would be any advantage. This website has a calculator that addresses this issue; http://www.fincalc.com/ (Speaking with his tax/financial advisor about it would be a good idea also) This is a bit off the topic of what you asked but the idea of doing a conversion is attractive for some because it takes a pool of money that will be taxable over time when it is drawn out and converts it to a tax free pool by taxing it all at once. There are some limitations, but when you do a conversion, the entire sum of the conversion is added to the AGI and you pay income taxes on it. It is then (basically) instantly placed in a Roth account where it can be invested, allowed to grow tax deferred and when it is drawn out, is completely tax free.

Reading IRS regulations is a bit like watching grass grow, but from what i gathered by reading the publications i linked below, i am not sure why your friend was told he had contributed too much.

Limit on Elective Deferrals
There is a limit on the amount an employee can defer each year under these plans. This limit applies without regard to community property laws. Your plan must provide that your employees cannot defer more than the limit that applies for a particular year. For 2006, the basic limit on elective deferrals is $15,000. (For 2007, this limit increases to $15,500.) If, in conjunction with other plans, the deferral limit is exceeded, the difference is included in the employee's gross income.
Catch-up contributions. A 401(k) plan can permit participants who are age 50 or over at the end of the calendar year to also make catch-up contributions. The catch-up contribution limit for 2006 and 2007 is $5,000. Elective deferrals are not treated as catch-up contributions for 2006 until they exceed the $15,000 limit, the ADP test limit of section 401(k)(3), or the plan limit (if any). However, the catch-up contribution a participant can make for a year cannot exceed the lesser of the following amounts.
*The catch-up contribution limit.
*The excess of the participant's compensation over the elective deferrals that are not catch-up contributions.

From; http://www.irs.gov/publications/p560/ch04.html#d0e2474

It seems to me that he was within the guidelines of being able to contribute $20,500 because he is older than 50, even if, as you stated, "It appears, however, that not enough lower paid employees contribute". Employees are not required to contribute to a standard 401(K) plan but employers are prohibited from discriminating in favor of higher paid employees. In other words, an employee must be allowed to participate but can not be forced to and if he does, the same contribution and matching provisions would apply to the guy making $40,000 a year as to the guy making $100,000 a year. The company can not have a higher matching percentage for the manager than it does for the loading dock worker UNLESS it is a so called "top-heavy" plan.

How the excess is returned is treated is discussed in this publication;
http://www.irs.gov/publications/p525/ar02.html#d0e2242

When the document opens, click on "Retirement Plan Contributions"

If i read it correctly, and from what i understand about these plans, since the $5,000 that was contributed was done so pre=tax, the five grand would be added to his AGI for the year in which it was returned. At that point he is most certainly free to use it however he sees fit, including opening a Roth IRA. He will have now paid taxes on that money. Also, since he is over 50 years old, he can contribute up to $5,000 in 2007 to a Roth and in '08 the limit will go to $6,000.

Hope that helps.

[question everything]

2. Thank you for a very detailed information

The way I understand it, the IRS does not want only people earning at the higher level, say, 100K, taking advantage of the plan. (Of course, if the employer were more generous in its pay plan perhaps more lower paid employees would have participated - another subject).

What bugs him, and a few other co-workers in the same boat, is that they were notified just on Friday, with only one paycheck left to adjust their withholdings.

He requested that the $5K, or so, be paid in 2008 so it will not be part of his 2007 taxable income, however he will owe more tax because his pre-tax contribution to 401K will now be reduced by $5K. At least this is my understanding.

I thought that Congress passed a law last year, or in 2006, where employees would be automatically enrolled in 401K, in conservative funds and it would be up to them to opt out, rather than the way it is done now.

About converting IRA to Roth - I, too, have been toying with it but I will have to pay more taxes on it, while I do expect to be on a lower bracket upon retirement (which was the original idea of the IRA and 401K, I think).

Thanks, again.

[A HERETIC I AM]

3. Another snippet from IRS Pub 525 & 560....

Again, this can be as tedious to read as watching paint dry....

Excess deferrals. - If your deferrals exceed the limit, you must notify your plan by the date required by the plan. If the plan permits, the excess amount will be distributed to you. If you participate in more than one plan, you can have the excess paid out of any of the plans that permit these distributions. You must notify each plan by the date required by that plan of the amount to be paid from that particular plan. The plan then must pay you the amount of the excess, along with any income earned on that amount, by April 15 of the following year.

You must include the excess deferral in your income for the year of the deferral unless you have an excess deferral of a designated Roth contribution. File Form 1040 to add the excess deferral amount to your wages on line 7. Do not use Form 1040A or Form 1040EZ to report excess deferral amounts.

Excess not distributed. - If you do not take out the excess amount, you cannot include it in the cost of the contract even though you included it in your income. Therefore, you are taxed twice on the excess deferral left in the plan—once when you contribute it, and again when you receive it as a distribution.

Excess distributed to you. - If you take out the excess after the year of the deferral and you receive the corrective distribution by April 15 of the following year, do not include it in income again in the year you receive it. If you receive it later, you must include it in income in both the year of the deferral and the year you receive it. Any income on the excess deferral taken out is taxable in the tax year in which you take it out. If you take out part of the excess deferral and the income on it, allocate the distribution proportionately between the excess deferral and the income.

You should receive a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., for the year in which the excess deferral is distributed to you. Use the following rules to report a corrective distribution shown on Form 1099-R for 2007.

*If the distribution was for a 2007 excess deferral, your Form 1099-R should have the code “8” in box 7. Add the excess deferral amount to your wages on your 2007 tax return.
*If the distribution was for a 2007 excess deferral to a designated Roth account, your Form 1099-R should have code “B” in box 7. Do not add this amount to your wages on your 2007 return.
*If the distribution was for a 2006 excess deferral, your Form 1099-R should have the code “P” in box 7. If you did not add the excess deferral amount to your wages on your 2006 tax return, you must file an amended return on Form 1040X, Amended U.S. Individual Income Tax Return. If you did not receive the distribution by April 17, 2007, you also must add it to your wages on your 2007 tax return.
*If the distribution was for a 2005 excess deferral, your Form 1099-R should have the code “D” in box 7. If you did not add the excess deferral amount to your wages on your 2005 tax return, you must file an amended return on Form 1040X. You also must add it to your wages on your 2007 income tax return.
*If the distribution was for the income earned on an excess deferral, your Form 1099-R should have the code “8” in box 7. Add the income amount to your wages on your 2007 income tax return, regardless of when the excess deferral was made.

Report a loss on a corrective distribution of an excess deferral in the year the excess amount (reduced by the loss) is distributed to you. Include the loss as a negative amount on Form 1040, line 21 and identify it as “Loss on Excess Deferral Distribution.”

Bold and underscored text added for emphasis

So...unless I am reading that wrong (a distinct possibility!) or there is some other provision that makes the circumstance different, if he does not want to pay tax on the five grand twice, he needs to take it before April 15th and it will be seen as income for '07

Here's part of Pub 560 that talks about Automatic Enrollment;

Automatic enrollment in a 401(k) plan. - Your 401(k) plan can have an automatic enrollment feature. Under this feature, you can automatically reduce an employee's pay by a fixed percentage and contribute that amount to the 401(k) plan on his or her behalf unless the employee affirmatively chooses not to have his or her pay reduced or chooses to have it reduced by a different percentage. These contributions qualify as elective deferrals. For more information about 401(k) plans with an automatic enrollment feature, see Regulations section 1.401(k)-1.

Traditional 401(k) plans. A traditional 401(k) plan allows eligible employees (i.e., employees eligible to participate in the plan) to make pre-tax elective deferrals through payroll deductions. In addition, in a traditional 401(k) plan, employers have the option of making contributions on behalf of all participants, making matching contributions based on employees’ elective deferrals, or both. These employer contributions can be subject to a vesting schedule which provides that an employee’s right to employer contributions becomes nonforfeitable only after a period of time, or be immediately vested. Rules relating to traditional 401(k) plans require that contributions made under the plan meet specific nondiscrimination requirements. In order to ensure that the plan satisfies these requirements, the employer must perform annual tests, known as the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests, to verify that deferred wages and employer matching contributions do not discriminate in favor of highly compensated employees. From ; http://www.irs.gov/retirement/sponsor/article/0,,id=151800,00.html

Partnership. - A partnership can have a 401(k) plan.

Restriction on conditions of participation. - The plan cannot require, as a condition of participation, that an employee complete more than 1 year of service.

Matching contributions. - If your plan permits, you can make matching contributions for an employee who makes an elective deferral to your 401(k) plan. For example, the plan might provide that you will contribute 50 cents for each dollar your participating employees choose to defer under your 401(k) plan.

Nonelective contributions. - You can, under a qualified 401(k) plan, also make contributions (other than matching contributions) for your participating employees without giving them the choice to take cash instead.

[question everything]

4. So he should look for a code 8 on his 1099-R

Meanwhile, he checked his 401K online and realized that a "distribution" has already been issued and income tax has been withheld.

Now, if the W-2 form says that 401K contribution has been $15,500 and the taxable income higher, I wonder whether this would mean that his withholdings were not enough.

This is why all of them are so mad. That they waited until the last week of 2007 when it is hard to try to see what can be salvaged.

Again, thanks for looking up the info.