If you make the mistake of putting too much money into your 401(k), you’ll run into a tax issue called an excess contribution. You will owe an extra 6% income tax on the amount that you have over contributed. You’ll also be charged an extra 6% each year that you don’t remove the excess amount. You can avoid all of these extra fees by withdrawing the excess amount quickly.
Excess Deferral Correction
Overfunding your 401(k) account, known as an excess deferral, can have financial consequences. The IRS allows employees to contribute a limited amount to their 401(k) plans each year. Excess contributions above the limit are subject to penalties.
The excess deferral limit for 2023 is $22,500 (plus a catch-up contribution limit of $7,500 for those age 50 or older).
- Employer Error: If the overpayment is due to an employer error, the employer must correct it by distributing the excess funds to you by April 15th of the following year.
- Employee Error: If you overpay due to your own mistake, there are two options for correction:
- Same-Year Correction: Withdraw the excess amount before the tax filing deadline (April 15th). You’ll owe income tax and a 10% penalty on the excess, but you can avoid an additional 6% excise tax.
- Recharacterization: Move the excess funds to a traditional IRA (if eligible) by December 31st of the following year. No tax or penalty will apply, but the contribution will not count towards your 401(k) limit for the year.
| Option | Taxable | 10% Penalty | 6% Excise Tax |
|---|---|---|---|
| Same-Year Correction | Yes | Yes | No |
| Recharacterization | No | No | No |
It’s important to monitor your 401(k) contributions regularly to avoid overpayments. If you notice an excess deferral, consult with your plan administrator or a tax professional to determine the best course of action.
Tax Penalty
If you exceed the annual contribution limit for your 401(k) plan, you will face a penalty. The penalty is equal to 6% of the excess amount, and it is paid each year that the excess amount remains in the account.
For example, if you contributed $25,000 to your 401(k) in 2023, but the annual contribution limit was only $22,500, you would have an excess contribution of $2,500. You would owe a penalty of $150 (6% of $2,500) each year that the excess amount remains in the account.
There are a few ways to avoid the penalty for overfunding your 401(k):
- Correct the excess contribution by withdrawing the excess amount plus any earnings attributable to the excess amount. This must be done by the tax filing deadline for the year in which the excess contribution was made (including extensions).
- Recharacterize the excess contribution as a traditional IRA contribution, if you are eligible. This must also be done by the tax filing deadline for the year in which the excess contribution was made (including extensions).
- Report the excess contribution on your tax return and pay the 6% penalty. The excess contribution will be subject to income tax and the 10% early withdrawal penalty if you are under age 59½.
The following table summarizes the options for correcting an excess 401(k) contribution:
| Option | Description |
|---|---|
| Withdraw the excess contribution | Withdraw the excess amount plus any earnings attributable to the excess amount by the tax filing deadline for the year in which the excess contribution was made (including extensions). |
| Recharacterize the excess contribution | Recharacterize the excess contribution as a traditional IRA contribution, if you are eligible. This must also be done by the tax filing deadline for the year in which the excess contribution was made (including extensions). |
| Report the excess contribution on your tax return | Report the excess contribution on your tax return and pay the 6% penalty. The excess contribution will be subject to income tax and the 10% early withdrawal penalty if you are under age 59½. |
Impact on Retirement Goals
Exceeding the annual contribution limit for a 401(k) can have significant implications for your retirement strategy. Here are the potential impacts:
- Excess Contributions Tax: Contributions above the limit are subject to a 6% excise tax for each year the excess remains in the account.
- Reduced Investment Returns: The excess contributions are not eligible for tax-deferred growth, potentially reducing your overall investment returns.
- Early Withdrawals: Excess contributions withdrawn before age 59½ may be subject to an additional 10% early withdrawal penalty.
- Contribution Delay: The excess contributions may need to be returned to you, which can delay your retirement savings strategy.
| Contribution Limit | 2023 | 2024 |
|---|---|---|
| Standard Contributions | $22,500 | $23,500 |
| Catch-Up Contributions (Age 50+) | $7,500 | $8,000 |
To avoid these negative consequences, it’s crucial to contribute to your 401(k) within the established limits. Monitor your contributions throughout the year to ensure you don’t exceed the maximum amount allowed.
Reporting and Repayment
Overpaying into a 401(k) can have tax implications and requires timely action to rectify. If you find out that you have overpaid, it’s important to report the excess contribution to the IRS and take steps to withdraw the funds.
Reporting
- Form 5330: Complete and file Form 5330, Return of Excise Taxes Related to Employee Benefit Plans, to report the overpayment and calculate any excise tax that may be due.
- Tax Return: Report the overpaid amount on your income tax return for the year in which the overpayment occurred.
Repayment
You have two options for withdrawing the excess contribution:
- Withdrawal within 60 Days: If you withdraw the funds within 60 days of making the overpayment, you can avoid any excise tax on the excess amount. You will still need to pay income tax on any earnings that have accrued on the overpayment.
- Distribution after 60 Days: If you withdraw the funds after 60 days, you will have to pay a 6% excise tax on the excess amount for each year that it remains in the account. You will also pay income tax on any earnings that have accrued on the overpayment.
Note: If you withdraw the funds after the end of the calendar year in which the overpayment occurred, you will have to include the overpayment in your income for the year in which the funds are withdrawn.
Table of Tax Implications
| Excess Contribution | Withdrawal Within 60 Days | Withdrawal After 60 Days |
|---|---|---|
| Less than $500 | No excise tax | 6% excise tax per year |
| $500 or more | Income tax on earnings | 6% excise tax per year and income tax on earnings |
Well, folks, there you have it! Overpaying into your 401(k) is something to be aware of. If you find yourself in this situation, don’t freak out. Follow the steps we outlined, and you should be able to get things sorted out. Thanks for hanging out and reading our article. If you have any other questions or concerns about your finances, be sure to visit our site again soon. We’re here to help you navigate the money maze with ease and confidence.