We recently got this interesting question from a reader named Jeff:
I know the IRS limit for 401k contributions is currently $17.5k / yr. What I want to know is what actually happens if I contribute more than that, say $20k? Do I get a stiff penalty? Do I go to 401k jail? Is this handled like a Roth IRA?
Jeff is right about the 401(k) contribution limit for 2013. It’s $17,500 for an individual. It’ll stay the same in 2014.
Most of us won’t have to worry about contributing more than that $17,500 limit. Even if you have enough money available to over-contribute to a 401(k), your plan administrator will likely keep you from contributing too much in one year.
This is a slightly more common problem, though, if you switch jobs during the year, or if you work two jobs and have a 401(k) with both. In this case, you’ve got to be extra careful that you work with plan administrators to ensure that your total 401(k) plan contributions for the year don’t exceed $17,500 (plus $5,500 for catch-up contributions if you are 50 or older).
Besides communicating with your employer if you’re in one of these situations, the best thing you can do is to stay on top of your 401(k) contributions. The sooner you notice an over-contribution mistake, the sooner you can fix the problem.
How to Remedy an Over-Contribution
According to the IRS, if you over-contribute to your 401(k) in 2013, you’ll have until April 15, 2014, to withdraw the excess amount. The excess amount (plus any interest earned on that amount) will be added to your gross income for the year and will be taxed accordingly.
So if you accidentally contributed $18,500 between two employer plans in 2013, you’d have until April 15 to withdraw the extra $1,000 plus any interest that money earned. The interest earned will be added to your taxable income for the year.
It doesn’t matter how much you contribute over the limit. The same rules apply. It’s just that the more you over-contribute, the bigger your tax bill will be.
Because of the slow-moving nature of some 401(k) plans, it’s important to get your over-contribution correction in gear as soon as possible. It’s best if you initiate the withdrawal by March 1.
This means that you need to stay on top of your contributions for the previous year. Check them in January or February, just to ensure that you don’t miss any over-contributions.
Consequences After April 15
In many cases, individuals don’t notice that they’ve over-contributed to a 401(k) plan. So what happens if you contribute too much but don’t notice it before April 15?
In this case, the excess contribution basically is taxed twice. Even if you fail to withdraw that extra $1,000 from the above example by April 15, you’ll have to pay income taxes on it.
Plus, because that money wasn’t a legitimate contribution to your 401(k), you’ll have to pay taxes on it again when you withdraw it.
Double-taxation is never a good thing, and depending on how much you over-contributed, this could make for some hefty financial consequences.
Employer Contributions Don’t Count
One thing to note here is that employer contributions do not count against your $17,500 401(k) contribution limit. So if your employer has a matching program, you can contribute your $17,500 plus the employers’ matching amount.
As long as your contributions from your own pay are $17,500 or less for 2013 and 2014, you don’t have to worry about any of this.
IRAs are Similar
If you have an IRA, you’re also subject to contribution limits – $5,500 (or $6,500 for those 50 and older) in 2013 and 2014. If you contribute more, you have until April 15 to remedy the situation.
Penalties are heftier, though, for IRA over-contributions. You’ll pay a 6 percent tax penalty on the money for each year it remains in your account.
If You Have More to Contribute
I suspect that part of the reason Jeff asked his question is that he has more than $17,500 he’d like to save for retirement in a given year. In this case, it’s best to have multiple retirement plans, but to follow the rules closely for each plan. For example, you might max out your 401k and open a tax deductible or Roth IRA (assuming your income doesn’t disqualify you).
If you’d like to contribute much more than the $17,500 limit to your retirement accounts this year, talk with an investment professional about how best to allocate your money. You’ll want to get the most bang for your buck – without running awry of the IRS.