Tax Tip: Question arises on 401(k) refund, making an “excessive contribution” (inadvertently)

Tennessee CPAs Jennifer Broyles and Heather Martin answer questions for knoxvillebiz.com:   Q: I have money removed from my paycheck for a 401(k). I put in the full amount that I am allowed in 2012, but my company decided to return $3,913.40 without my permission. Something about not everyone in the company, contributed the full amount like I do. I had to count this as income on my Federal return. I received a check and a Form 1099-R from my 401(k) company, JP Morgan Retirement Plan Services.  They took out $391.34 in Federal income tax on the refund. Box 7 Dist. Code shows number 8. Only boxes 1, 2A, 4. 7, 13 and 14 were filled. I noticed that they showed $3,913.40 in the State Distribution box 14 (State in box 13 was Tennessee), When I run my tax software, it tells me that I am due a refund from Tennessee for $3,913.49, if I file a state return. This is news to me. First of all, did JP Morgan take out enough taxes ($391.34) and is the tax software wrong about the refund from Tennessee? Neither I nor my wife have enough distributions to file a Tennessee return, otherwise. — J Maddox 

A: From these details, it sounds like you have made an “excess contribution” (inadvertent, of course) to your company’s 401(k) plan. In these instances, the plan is required to
return the excess contribution amount to you, but because that contribution has never been taxed (since you were contributing pretax dollars), the amount returned to you must be reported on Form 1099-R, and included in your taxable income in that year. 

The IRS requires that non-periodic payments of pensions and annuities have federal income tax withheld at a flat 10 percent rate, unless the recipient chooses not to have income tax withheld at all.  Non-periodic payments are defined as those payments that are not made in installments, at regular intervals, over a period of more than one year, and are payable on demand. Your case would be considered non-periodic, so it looks like JP Morgan did appropriately withhold the mandatory 10 percent of the gross distribution amount.
The decision of whether or not that 10 percent will be sufficient to cover your tax liability is another question entirely, and will depend on your overall tax situation and your personal effective tax rate. If your personal effective tax rate is greater than 10 percent, then it is likely that you will owe additional federal tax on the income. Otherwise, the amount withheld by JP Morgan should be enough to cover the tax owed. 

To the second part of your question — an excess contribution distribution reported on a 1099-R does not trigger the requirement for you to file a Tennessee Individual Income Tax Return, nor should you be due a refund from the state of $3,913.49.  It sounds as though the amount from box 14 (State Distribution) of the 1099-R has been entered into your tax preparation software as Tennessee tax withheld, which is not correct. (Any Tennessee tax withheld would have been reported in box 12 of the Form 1099-R). 
 
By generating a Tennessee Individual Income Tax Return, the software is attempting to refund the amount of Tennessee tax withheld to you since you have no Tennessee tax liability owed. But, since there was no Tennessee tax actually withheld, you would not be due a refund and have no Tennessee filing requirement.