What to Do if You Over-Contributed to Your 401(k)
A 401(k) retirement account is a tax-advantaged account that an employer offers to an employee. This company-sponsored plan is one of the best savings and investment vehicles you can use for your retirement planning. The account lets you contribute up to a fixed number of funds per year. On top of this, you also get an employer match if your company offers the provision. There are different types of 401(k)s, like a traditional and a Roth 401(k). In a traditional 401(k), your contributions are made from your pre-tax income, thereby, reducing your taxable income however, your withdrawals are taxed. On the other hand, in a Roth 401(k), you make contributions with after-tax income but can make tax-free withdrawals in retirement. Further, the 401(k) account also provides the option to take a loan against your funds if you are in need of financial assistance during an emergency.
One of the best recommendations that you may have commonly heard in regard to the 401(k) is to maximize your contributions. Doing so ensures that you are on the right track to retirement financial security. It helps you maximize your savings and tax benefits and speeds up your journey towards your desired retirement nest egg. However, there is also a pitfall sometimes. In your eagerness to contribute to your 401(k), you may mistakenly over-contribute to your account. This can have certain drawbacks.
Find out more about this, what happens if you over-contribute, and what to do in such a situation. You could also consult with a professional financial advisor who can explain the pros and cons of 401(k)s, their taxability, and how you can build a substantial retirement corpus with the help of 401(k)s.
What is a 401(k) over-contribution?
The Internal Revenue Service (IRS) allocates contribution limits for retirement accounts like the 401(k) for every financial year. As of 2022, you can contribute up to $20,500 to a 401(k) per annum. If you are aged 50 or older, you make an additional catch-up contribution of up to $6,500, bringing your total to $27,000. For the year 2023, the IRS has announced increased limits increasing the contribution to $22,500 per annum along with an additional catch-up contribution of up to $7,500 for those aged 50 and above, bringing the total to $30,000.
A 401(k) over-contribution is when you contribute more than these limits. For instance, if you are 49 years old and you contribute $21,000 to a 401(k) in 2022, this will be considered an over-contribution.
Here are some essential points to note about an over-contribution:
- A catch-up contribution is not an over-contribution
- An employer match is not an over-contribution. In this case, the IRS has set different limits. The maximum limit for the same is $61,000 and $67,500, including catch-up contributions for 2022, and $66,000 and $73,500, including catch-up contributions for 2023.
Is it possible to over-contribute to 401(k)?
Yes, it is possible to over-contribute to a 401(k). You may do so in error or if you are unaware of the latest limits approved by the IRS. Here are some common instances where this can happen:
1. When you switch jobs:
Switching jobs can make your 401(k) contributions confusing and complicated to keep track of. If your old and new employer both offer a 401(k), you may end up with two 401(k) accounts. In this case, keeping up with the contributions can be challenging. A lot of investors think that the contribution limits apply to each account. However, these limits are applicable to all your 401(k) accounts together. Irrespective of whether you have one 401(k) or more, you can only contribute up to the maximum limit in one year.
2. When you have more than one job:
If you work multiple jobs, including full and part-time jobs, you may again have more than one 401(k). A lot of companies offer a 401(k) to part-time employees as well. While this is a great benefit, you must be mindful of your total contributions. It is easy to get lost among multiple accounts and lose sight of your approved limits.
3. When you receive a bonus or an income raise:
Many companies offer the option to set up automatic contributions to your 401(k) account. This is an easy way to ensure that you never skip out on contributions and are able to be consistent in your savings. Typically, you can set a percentage of your income to be automatically deducted from your salary and deposited into your 401(k). However, if you receive a bonus on a specific month or your income raises, the value of your contributions can also increase. This may go unnoticed if you do not pay attention and adjust your automated transfers, resulting in a 401(k) over-contribution.
What happens if you contribute too much to 401(k)?
Here’s what unravels if you have mistakenly or unknowingly over-contributed to a 401(k):
1. 10% penalty:
The first brunt you bear is in the form of a penalty. As per 401(k) rules, all distributions made before the age of 59.5 years are considered early withdrawals and imposed a 10% penalty. If you exceed the contribution limit, you will have to withdraw the excess funds from the account. The IRS will impose a flat 10% penalty on this withdrawal as it is seen as an early withdrawal.
2. Double tax:
Along with the 10% penalty, you will also pay tax on your withdrawn amount. You will be taxed twice, first when you over-contribute and then when you make the correction. Since you may have accrued earnings on your over-contributions, you need to add them to your taxable income.
What to do if you have over-contributed to a 401(k)?
Thankfully, there are ways to reverse an accidental 401(k) over-contribution. If you find yourself in such a situation, here are the steps you can follow:
1. Inform your employer:
As soon as you spot the over-contribution, make sure to alert your employer immediately. You must do so before March 1 of the year the over-contribution was made so the excess funds can be returned to you by April 15.
2. Fill out form 1099-R:
If you have earned an income from the excess contribution, it will reflect on your tax bill for the year. It could increase your tax output or lower your refund. Therefore, you need to report the same to the IRS via form 1099-R.
3. Get a new W-2 from your employer:
Form W-2 is filled and submitted by employers. It is used to report wages paid to an employee and the value of taxes withheld from them by a company. Since the returned over-contribution will be added to your taxable wages for the year, you will have to ask your employer to submit a new W-2 form.
How can you avoid a 401(k) over-contribution?
Even with all the drawbacks and liabilities that come with a 401(k) over-contribution, it does point to the fact that you have surplus funds. Having more money to save or invest is an excellent advantage to have. However, in order to not waste it in an over-contribution, it is vital to use it wisely. Here are some things you can do to ensure you never witness such a situation:
1. Be up to date about the contribution limits:
A lot of people need help understanding the products they put their money in. The 401(k) retirement account is one of the most commonly used retirement savings vehicles, as most employers offer it. You may be investing in it as part of your employee benefits without even knowing what it is or how it can add value to your life. This most commonly happens to youngsters or people who have just started their professional journeys. Try to educate yourself as early in your career as possible to avoid the scope of such mistakes.
The contribution limits are set by the IRS and may change every financial year. They are typically announced at the end of the year to prepare investors and offer them enough time to plan their investments for the coming year. It is essential to keep track of these announcements and make a note of them so you do not miscalculate your contributions. You can check the IRS website. This is a government website which can offer authentic and accurate information. You can also read the latest rules in newspapers or refer to the news on television. Companies also educate their employees from time to time. So, keep an eye out for any email or announcement at work. Additionally, if you have any doubts, you can walk up to the finance or human resource department and get clarity on your query.
2. Reviews your financial plans periodically:
Automated contributions are one of the most common reasons leading to an over-contribution. Automation can be helpful as it can be hard to follow up on every investment. However, it can also be detrimental if you forget about your investments altogether. It is vital to keep checking your contributions, the performance of your assets, the frequency of your investments, and other similar details after regular intervals. This will allow you to take control of your accounts.
Reviewing your investments becomes even more critical if you have changed your jobs. In this case, it may be advised to shift your money from the old 401(k) to the new employer’s 401(k). This simplifies management and eliminates the chances of negligence. However, before you do so, make sure you check the investment options, rules, loan procedures, etc., offered by the new employer to make an informed decision.
If you work multiple jobs, remember to review each of your 401(k)s periodically to keep track of your overall investment. You may receive an employer match from one job and a raise in another. All of these events will impact your 401(k) contributions. So, try to be as watchful as possible.
3. Maintain a diversified portfolio:
Maintaining a diversified portfolio is essential for a number of reasons. It helps lower risk, maximizes gains, and offers exposure to multiple sectors, industries, assets, market capitalizations, and more. A diversified portfolio refers to an investment bank where you invest more options other than your 401(k) retirement account. So, when you have surplus funds, you can divert them to better investments and earn higher returns. For instance, if you get a promotion and a salary hike, you can consider opening an Individual Retirement Account (IRA) and investing the excess funds in it. If you have a traditional workplace 401(k) account, a Roth IRA can also offer you tax diversification. Moreover, you will be able to contribute more towards your retirement nest egg without risking penalties or dual taxation. You can also consider other options, such as stocks, mutual funds, exchange-traded funds, real estate, real estate investment trusts (REITs), gold, certificates of deposit, government bonds, treasury bills, and more. The market is full of options, and you add multiple investment tools to your portfolio aligned to your financial goals, risk appetite, and budget.
4. Consult a financial advisor:
A financial advisor can help you navigate multiple investments, keep track of contribution limits, stay up to date with tax laws, take corrective actions in the case of an error like a 401(k) over-contribution and more. Hiring a financial advisor can be a brilliant investment in itself. Working professionals may have numerous commitments. Your personal life may also entail several responsibilities. Taking time to track every investment or remembering the contribution rules for every instrument can be challenging. However, you can delegate all of this to a financial advisor. Hiring a financial advisor can also help you ensure that your retirement planning is on point and you have help in other areas of personal finance, such as tax planning, budgeting, savings, estate planning, education planning for kids, and more.
Choosing the right financial advisor is daunting, especially when there are thousands of financial advisors near you. We make it easy by matching you to vetted advisors that meet your unique needs. Matched advisors are all registered with FINRA/SEC. Click to compare vetted advisors now.
Over-contributing to your 401(k) is a common mistake that most people commit at some time in their life. It can happen to anyone. So, do not stress yourself over it. The important thing is to identify it early and take remedial action as soon as possible. While you may not be able to avoid the penalty and the tax, you can take it as a learning opportunity and make sure it does not happen again. It also helps if you are up to date and aware and understand the investments you put your money in to avoid blunders.
Lastly, consider hiring a financial advisor in your area to simplify things further. Use the free advisor match service to connect with 1-3 financial advisors based on your financial requirements. All you need to do is answer a few simple questions about yourself and the match tool will help connect you with advisors suited to meet your financial needs and goals.
About Dash Investments
Dash Investments is privately owned by Jonathan Dash and is an independent investment advisory firm, managing private client accounts for individuals and families across America. As a Registered Investment Advisor (RIA) firm with the SEC, they are fiduciaries who put clients’ interests ahead of everything else.
Dash Investments offers a full range of investment advisory and financial services, which are tailored to each client’s unique needs providing institutional-caliber money management services that are based upon a solid, proven research approach. In addition, each client receives comprehensive financial planning to ensure they are moving toward their financial goals.
CEO & Chief Investment Officer Jonathan Dash has been profiled by The Wall Street Journal, Barron’s, and CNBC as a leader in the investment industry with a track record of creating value for his firm’s clients.