Inadvertent Benefit Overpayments: Understanding the Rules
By Jennifer Bassett, CIP, CISP, CHSP, QKA
The Setting Every Community Up for Retirement Enhancement (SECURE) 2.0 Act and Notice 2024-77 provide the latest official guidance on handling inadvertent benefit overpayments (IBOs). This guidance is crucial for plan sponsors to ensure compliance and avoid disqualification of their plans.
The guidelines for handling overpayments are optional, not mandatory. They apply to operational failures that occurred on or after October 15, 2024, and are relevant to various plan types, including 401(a), 403(a), 403(b), and governmental plans.
Overpayments Occurring Before SECURE 2.0
Before the SECURE 2.0 Act, plan sponsors had three options to correct overpayments. The IRS’ Employee Plans Compliance Resolution System (EPCRS) provided these options in Revenue Procedure 2021-30.
The payee could return the overpayment.
The plan sponsor could make a contribution in order to make the plan whole.
The plan sponsor could retroactively amend the plan document.
Overpayments Occurring After SECURE 2.0
Under SECURE 2.0, a plan will not become disqualified due to overpayment if the plan sponsor
fails to obtain payment because of an IBO, or
amends the plan to either increase past or decrease future benefit payments to adjust for the IBO (the amendment must not result in another failure).
Eligible Inadvertent Failures
This failure can occur even when established practices and procedures are in place. This excludes any failure that is egregious, involves the diversion or misuse of plan assets, or is directly or indirectly connected to abusive tax avoidance transactions.
IBOs
An IBO is an eligible inadvertent failure that exceeds the amount allowed under the plan terms or limits set by the Internal Revenue Code or Treasury Regulations. It also includes any payment made before the participant experiences a distributable event permitted by the plan (e.g., a payment made because of incorrect vesting or an inservice of deferrals distributed before age 59½)
An eligible inadvertent failure does not include an overpayment made
to a disqualified person under the prohibited transaction rules,
to an owner-employee, or
pursuant to a correction under EPCRS for another failure.
For example, if a participant exceeded the IRC Sec. 402(g) limit ($23,500 for 2025) and that money was distributed to the participant, the amount distributed cannot simultaneously be an IBO. This amount is not an eligible rollover distribution.
Handling IBOs
Plan sponsors may, but are generally not required, to recover IBOs. If a plan sponsor decides to recoup an IBO, it must follow specific requirements, some of which are mentioned below.
A plan sponsor cannot seek recovery if the IBO occurred more than three years before the participant or beneficiary received written notice about the error, except in cases of fraud or misrepresentation.
The plan sponsor must notify the participant.
There can be no recovery of the IBO from the participant’s spouse or beneficiary.
The plan sponsor cannot charge fees associated with recovering the IBO.
The plan sponsor cannot recoup interest on the IBO.
Eligible Rollover Distributions vs. Noneligible Rollover Distributions
When IBOs are rolled over to another plan or to an IRA, they are categorized as either eligible rollover distributions (ERDs) or noneligible rollover distributions (NERDs).
ERDs: These are IBOs that the plan sponsor does not try to recover, and that would otherwise qualify as ERDs except for the overpayment itself. An ERD can also include IBOs that are being recovered and returned to the plan by a participant or beneficiary. These are treated as rollover contributions, regardless of whether the plan typically allows for rollovers. There is no need to apply for a waiver of the 6 percent IRA excess contribution penalty tax or the 10 percent early distribution penalty tax.
The following options apply when an ERD is rolled over to an IRA.
If the plan sponsor does not attempt to recover the IBO, no reporting changes are required (i.e., the transaction can still be reported as a rollover).
If the plan sponsor does attempt to recover the IBO, the amount rolled over can still be treated as an ERD and no reporting changes are required. If the amount is returned to the original plan, the financial organization holding the IRA and the original plan sponsor can report the repayment back to the original qualified plan as a rollover, even if the plan does not accept rollover contributions.
NERDs: These include IBOs that the plan sponsor tries, but fails to recoup. The plan sponsor must notify the individual that the overpayment is a NERD. The following options apply when a NERD is rolled over to an IRA.
If a NERD is returned to the original qualified plan from which the IBO was sent, no reporting changes are required for the original overpayment rollover. The financial organization holding the IRA and original plan sponsor can report the repayment back to the original qualified plan as a rollover—even if the plan does not allow rollovers into the qualified plan.
If a NERD is NOT returned to the original qualified plan from which the IBO was sent, the receiving financial organization should treat the ineligible rollover amount as a regular IRA contribution on behalf of the IRA owner, reporting it as such on Form 5498, IRA C. The ineligible rollover amount will be reported in Box 1 and the amount eligible for rollover will be reported in Box 2 of Form 5498. The IRA owner can then remove the amount as an excess contribution if needed.
In addition, the original qualified plan sponsor should correct the Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., as necessary. Reporting should show only the eligible amount as a direct rollover (code G) to the IRA, and the ineligible rollover amount on a second Form 1099-R as a distribution by the plan, with the appropriate Form 1099-R distribution code.
Conclusion
Understanding the rules and regulations surrounding IBOs in retirement plans and IRAs is crucial for both plan sponsors and participants. By following the guidelines and requirements, IBOs can be managed effectively without causing significant issues for the retirement plan or its participants.
