Our policy has been that the correction of administrative errors involving Health Benefits Premium Conversion (HB-PC) cannot include retroactive adjustments to taxable income. This Letter revises that policy by requiring retroactive adjustments to taxable income in the event of certain administrative errors related to HB-PC.

Most administrative errors related to HB-PC involve either the deduction of the incorrect amount of FEHB premiums or the failure to process an FEHB plan enrollment or termination. The actions that agency payroll offices (APO) take to correct such errors will also adjust the affected employees' taxable income and tax withholdings, although perhaps in a subsequent tax year. Please see BAL 01-313, "Correction of Administrative Errors - Health Benefits Premium Conversion," for examples of this.

Administrative errors, however, also occur when agencies process elections to participate or waive participation in HB-PC. These errors will result in FEHB premium deductions that are incorrectly designated as "pre-tax" or "after-tax." If they are corrected prospectively, the impact of these errors on the tax liabilities of the affected employees will be permanent. Therefore, when FEHB premium deductions are incorrectly designated as "pre-tax" or "after-tax," taxable income and tax withholdings must be adjusted retroactively to the date the HB-PC participation election should have been effective.

The need to retroactively adjust taxable income and tax withholdings in this circumstance is illustrated by the following example:

Bob Lockhart had previously waived participation in HB-PC. He marries (a "qualifying life event") and elects to participate in HB-PC. Although his election to participate in HB-PC should have been effective on November 18, 2001, his employing agency does not process it. As a consequence, Mr. Lockhart remains a non-participant in HB-PC and his FEHB deductions are incorrectly designated as "after-tax." The error is not discovered until in March 2002.

• If Mr. Lockhart's taxable income is adjusted prospectively, he will experience an increased tax liability for both tax years 2001 and 2002. To resolve this inequity, Mr. Lockhart's agency must make his election to participate in HB-PC effective on November 18, 2001 (as it should have been), and adjust his taxable income and tax withholdings retroactively to this date.

Since the error was detected after Mr. Lockhart's Form W-2 had been filed for 2001, the APO must file a Form W-2c, correcting his "wages" and tax withholdings for 2001. In addition, the APO must adjust Mr. Lockhart's current year-to-date taxable income and tax withholdings retroactively to his first pay day in 2002.

If the Error Occurred in the Current Tax Year:

• Adjust year-to-date taxable income and tax withholdings retroactively to the date the HB-PC election should have been effective.

If the Error Occurred in a Prior Tax Year:

Adjust year-to-date taxable income and tax withholdings retroactively to the first pay day of the current tax year.
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• Correct "wages" and tax withholdings for the prior year(s) by filing corrected W- 2s or W-2c's.

Ruth Roth, who had previously waived participation in HB-PC, was in leave without pay (LWOP) status from September 2001 through December 2001. Ms. Roth chose to continue her FEHB coverage during her period of LWOP, incurring a debt to her agency for the employee contributions that were remitted to OPM on her behalf. Upon her return to pay status, she elected to participate in HB-PC, but her agency designated her "catch-up" FEHB premium deductions as "after-tax."

Her employing agency has made an administrative error -- as a participant in HB-PC at the time the deduction was taken, Ms. Roth's "catch-up" FEHB premium deductions should have been designated as "pre-tax." To correct its error, the agency redesignates all of Ms. Roth's catch-up FEHB deductions as "pre-tax." Because the error was corrected after the APO filed the Form W-2 for 2001, it files a Form W-2c, correcting Ms. Roth's "wages" and tax withholdings for 2001.

Robert A. Yuran, Chief Financial Policy Staff

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