I had an employee who started contributions to a 403(b) in 2012. It was withheld in December and has not yet been sent to the custodian. He has now changed his mind and would like to make no further contributions. The custodian does not want to open a small account for this employee which would remain small for years and years.

Is there a way to "undo" the contribution so that everyone is happy?

Give him the money, get him to sign off on the paperwork, and give him an amended W2 if he has one, and just pretend it never happened if he hasn't.

I would think your custodian already has a policy on this - most have a policy that any small accounts (those typically less than $5K) that do not have contributions made in the previous xx months (a year?) are automatically closed out. The employee has the option of taking the cash and paying the 10% early withdraweal fee or he can roll it to his IRA without penalty.