Maxing out your 401(k) contributions is a good thing. It means you’re taking full advantage of an employer-sponsored retirement account to help set yourself up for worry-free golden years.
But even with a diligent eye, it’s possible to make a 401(k) over-contribution. Discover the impacts and how to avoid this retirement savings snafu.
For the 2021 tax year, 401(k) contribution limits are up to $19,500. This is great compared to an Individual Retirement Account (IRA), which limits contributions to $6,000. (Those over the age of 50 may be able to contribute more than that, however.)
While hitting the maximum amount is a good thing, there are a few instances where you might find yourself going over the 401(k) contribution limit.
If you left a job with a retirement plan and your new company also has a retirement plan, you might have two separate 401(k) accounts. It’s possible to start a new job and leave your old 401(k) plan behind.
This gives you the chance to max out your 401(k) at your new job, forgetting that you already made contributions to your old 401(k).
If you have many jobs — with many different retirement accounts — it’s possible to lose track of how much money is where. While holding down many full-time jobs is hard, some companies offer retirement plans to part-time and contract workers.
If you have a few different jobs that offer this benefit, you might not be able to keep up with all your plans. It’s possible that you may over-contribute if you don’t keep track of each of them carefully.
Setting up automatic contributions to your employer-sponsored 401(k) is a great way to make sure you’ll max out your 401(k) without putting in a lot of effort. But you could go over if you get a pay bump or bonus.
When you get a bonus, any traditional deductions such as taxes are withdrawn like normal, and so are any contributions to your 401(k). If you’re maxing out your salary contributions, a bonus might put you over the limit.
A salary increase can put you over the limit as well. You may have set up your auto-contributions to max out throughout the year. If you get a pay bump, your contribution will go up as well. You may miss this increase and forget to adjust your auto-contributions.
–Bryan P. Koepp, SVP Wealth Planning Executive, Regions Bank
Since a 401(k) over-contribution can happen at any time, you should be prepared for how to tackle it if it happens to you. Keep in mind that you should start taking steps before Tax Day.
Talk to your plan administrator: Find out from your boss or human resources department who you need to talk to about your 401(k) plan. Get them on the phone and let them know you made excess contributions for the year and need to be paid back.
This takes time and not all plan administrators work quickly on these requests. Try to handle this as early as possible. You’ll need to get any excess contributions back and any earnings you made on those contributions.
Request new W-2s. You might have already gotten your W-2s from work. Once your excess contributions are adjusted, you’ll need new tax forms. Your taxable wages will now include your fixed earnings. Don’t file your taxes until you’ve gotten an updated W-2.
If you don’t handle your extra contributions by Tax Day, you’re going to be taxed twice: once for the year you over-contributed and again for the year your correction took place. You won’t be taxed twice if you made the corrective distribution before Tax Day of the year following the year the over-contribution took place.
For example, if you made a 401(k) over-contribution in 2020, you have until Tax Day 2021 to make the correction to avoid getting double-taxed.
Corrective distribution is simply when you correct the over-contribution mistake. But keep in mind that if you qualify for catch-up contributions by being 50 years of age or older, your over-contribution might save you from excess deferrals. As you’re settling this excess, knowing the tax laws can help.
Over-contributing to your 401(k) — even by accident — can happen to anyone. Whether you have a job change or a bump in pay, you could end up having excess contributions to your 401(k) in a few different instances. The important thing to be aware of is how to handle those extra contributions.
Make sure you contact your plan administrator before Tax Day, get new W-2s and adjust your tax bill for the upcoming year. Not handling your extra contributions could mean you get taxed twice for your contributions. This is less money in the long run that can go towards your retirement.