401k Rollover Overpayment, Employer Wants it Back

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Short Version: In 2009, Employer laid off my wife, she requested distribution of 401k, received both vested and non-vested portion of employer contribution. Rolled over to Fidelity IRA, now employer wants non-vested portion back. What is the best course of action?

Long Version: In Feb 2009, my wife was laid off from a small 4 person business. She requested her 401k distribution so she could roll it over to an IRA. She received a check for $7k. A month later, the Employer called her up and said that she only got the profit sharing distribution, not the 401k distribution. They sent another check for $10k.

In Jul 2010, the Employer's accountant emailed my wife and told her that they accidentally distributed her both the vested portion and non-vested portion of the employer contribution and that they wanted to do a trustee to trustee transfer with Fidelity to get back the $5800 overpayment. My wife emailed them back and said that she wanted all the quarterly statements that show how much was vested and how much wasn't and any gains or losses during this time. She also told them that we would approve the trustee to trustee transfer if a) there was no money out of our pocket beyond the non-vested portion and b) that we receive a statement saying that they would not come after us for more money in the future if they found that their audit was incorrect (based on the small amount of paperwork she received I actually calculated that they actually should be getting back close to $7k, their accountant was BAD at math)

We received paperwork from Fidelity about the request for the transfer, but never got a response from the employer. My wife emailed them again reminding them of what we requested. No response.

Cut to July 2011 and the Employer asked if we knew why the transfer had never happened. We explained to them what we asked for a year ago. They responded back that sorry they never responded, it must have fallen through the cracks, they gave us sub-par quarterly statements, agreed to pay any fees and would not request more funds in the future. (The quarterly statements still had the errors in them, but to my wife's favor, so we decided to go ahead). In the mean time, she has also gained 27% since the money was deposited.

We called Fidelity and they said the only thing we could do was file an excessive contribution form, which would incur a 6% per year penalty from the IRS, 10% early distribution penalty and of course any income taxes associated with the distribution. We explained to them that the money would not be coming to us, but going directly back to the employer. They said they understood but this was the only route that was possible because it is a new tax year.

We have sent an email to the employer explaining what Fidelity described to us. We have not gotten a response. We are fully willing to give the money back as the official pension/401k policy was that she was only 20% vested, we just don't think it should cost us any money or significant time to make the employer whole.

My questions:

a) Is Fidelity correct that this is the only way we could get the money back to the employer? They did offer that we could do some tax amendments and say that we contributed to a non-deductible IRA and that would absolve us of some but not all of the penalties, but this would still cause time and money to be spent.

b) If Fidelity is correct, how much do we ask from the employer to make us whole so we aren't out any money because of these penalties?

Thanks in advance for the advice!

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i found a very similar situation to your wife's situation: link to fairmark forum

it's a very interesting situation that puts the former employer at risk of failing an irs audit, but it doesn't put your wife at any risk yet since they have not provided her with a revised 1099R showing the corrected reduced amount of the distribution.

in short, it sounds like the former employer doesn't know what to do since they are corresponding via email, and they have not issued a revised 1099R. i wouldn't be discussing anything with fidelity at this point until the former employer correctly identifies the overpayment via US mail and issues the revised 1099R. at that point, she needs to withdraw the excess from the fidelity plan but it looks like shee doesn't need to pay any income or excise tax due to the "incorrect rollover information" exception in the irs code. read the posts by "Alan S" in the fairmark thread.

if it were me, i would not correspond with the former employer since the burder in on them to correct their situation, and i would not correspond with fidelity yet. why should your wife spend her time and money trying to fix someone else's mistake? once they properly notify her of the overpayment amount, then the burden is on her to correct the situation in her fidelity ira by withdrawing the excess funds. now the interesting part comes into play. what to do with the excess funds? it looks like it becomes a moral obligation to return the funds to the former employer, but there appears to be no legal requirement to do so. if she keeps it she will need to pay taxes on it to satisfy irs requirements. i guess they can sue her to recover the funds but i doubt they would do that for $5800. if their mess causes your wife to deal with the irs in the unfortunate possibility of an audit, who will pay for her representation and time off work to resolve the matter? your wife will possibly need to refile her 2009, and possibly 2010 state and federal tax returns. will the former employer pay for that?

i'm not a tax or legal expert so you can probably post your question on the fairmark forum or other similar tax forums to get better advice than what you will probably get here.

edit: it looks like employers have successfully sued to get back overpayments issued to former employees: link
it's unfortunate that your wife's former employer's ineptness in handling the distribution and corrective measures may cause your wife some risk. you should seek sound tax accounting advice to ensure her taxes are properly filed, but her former company first needs to properly identify the overpayment.

edit: since the former company only had 4 employees, your wife should eventually pay back the excess distribution since it affects the other employees significantly.

Seems like getting hte money back from the 401k is going to be extremely messy.

Is there a reason why you can'pt just cut them a check for $5800 from your main accounts? Seems like that would be waaaaaay simpler?

Thank you momoman for that detailed response. I had not seen fairmark so I will read more over there. We fully intend to giveback the $5800 because it is not ours, but it should not cost us any money to do so. They have told us we'll get a revised 1099R but not until the transfer is complete. We will now ask for that first. I usually just do TurboTax for my taxes, but for this amendment I do think it is best to go to a professional, although I feel the employer should pay for that. There is no way I am going to use their accountant because i've already seen their horrible math on the paperwork they've sent my wife.

As for ensignlee, why would we give after tax money back to an organization that gave us money pretax, especially when we may have to pay penalties on that money as well?

ensignlee said:   Seems like getting hte money back from the 401k is going to be extremely messy.

Is there a reason why you can'pt just cut them a check for $5800 from your main accounts? Seems like that would be waaaaaay simpler?

Money in the checking account does not equal money in a 401k.

Looks like they're only sending you an email once a year every July... just humor them until next year.

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