Payroll in Practice: 4.3.2023

Question: How should the refund of excess pretax deductions from employee pay be handled after the end of the calendar year and issuance of Forms W-2?

Answer: How excess benefit deductions are refunded to an employee and reported to the Social Security Administration or IRS depends upon the specific benefit and taxes involved and when the refund occurs. Examples of excess pretax deductions include those for health savings accounts, certain qualified plans such as a 401(k), and benefits under a Section 125 cafeteria plan.

Pretax deductions for HSA contributions are treated as employer contributions and are exempt from income, Social Security, Medicare, and federal unemployment taxes. If employer contributions, including employee pretax contributions, exceed the limitation, the employer is to include the excess amount in the employee’s Form W-2, Wage and Tax Statement, for the tax year the contribution was made. If the W-2 has already been issued, the employer is to correct the W-2.

The employee is generally subject to a 6% excise tax on the excess contribution. The 6% excise tax may be avoided if the employee withdraws the excess contribution and any income earned on the withdrawn contributions by the due date, including extensions, of the employee’s tax return for the year the contribution was made.

If the withdrawn contribution was not included in Box 1 of Form W-2, the employee should report the excess amount as “other income” on their tax return for the year the contribution was made. The employer may be liable for any Social Security and Medicare taxes it failed to withhold.

However, the income earned on the withdrawn contributions should be included as “other income” on the employee’s tax return for the year the contributions were withdrawn.

As an alternative, the employee may be able to deduct excess contributions for previous years that are still in the HSA. The amount that may be deducted for the current year is the lesser of the employee’s maximum contribution limit for the current year minus any amounts already contributed for the year or the total excess contributions in the HSA at the beginning of the year. Any excess contributions remaining at the end of the tax year are subject to the 6% excise tax. See IRS Publication 969, Health Savings Accounts and Other Tax-Favored Health Plans, for more information on excess contributions.

Elective deferrals to a 401(k) plan are deferred pretax for income tax but are subject to Social Security, Medicare, and federal unemployment taxes at the time of deferral.

An employee can have an excess deferral paid out of the plan provided the plan permits these distributions. For an excess deferral made in 2022, the employee must notify the plan of the amount to be refunded no later than April 15, 2023. The plan must pay that amount plus earnings on that amount through the end of 2022.

If the excess deferral is distributed by April 15 of the year following the year of deferral, the excess is taxable in the deferral year, but the earnings are taxable in the year distributed. The distribution is not subject to the 10% excise tax on early distributions.

If the distribution occurs after April 15, the excess is taxable in both the year of deferral and the year distributed. That means the deferred amount is taxed twice. The earnings are taxable in the year distributed.

The distributions are reported on Form 1099-R, Distributions from Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. No correction of Form W-2 for the deferral year is required.

Under Section 125 cafeteria plan rules, administrative mistakes, such as excess pretax deductions, can cause disqualification of the entire cafeteria plan and inclusion of the benefits in the employee gross income. With certain specific exceptions, such as a 401(k) plan, a cafeteria plan cannot include a benefit that defers pay.

Any excess deductions discovered after the W-2 Forms have been filed should be corrected as soon as discovered. After calendar year end, income tax and Additional Medicare Tax withholding cannot be adjusted. Form W-2C Corrected Wage and Tax Statement should be used to correct the amounts of Income tax wages and Social Security and Medicare wages and taxes for the year the excess deduction occurred. Correction of the appropriate employer’s tax return (Form, 941, 943, or 944) and state wage reports may also be required.

This column does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Patrick Haggerty is the owner of a tax practice in Chapel Hill, North Carolina, and an enrolled agent licensed to practice before the Internal Revenue Service. The author may be contacted at phaggerty@prodigy.net.

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