What if you Over-Contribute to a 401K? (and a Case for Purposefully Doing so when you Change Jobs)
All good things come with limitations. And never is that more true than with retirement accounts.
For those lucky enough to have an employer-sponsored 401K (it is rarer that you think), you are probably aware that there is a maximum 401K contribution limit that you can contribute against each year, as determined by the IRS. This limit is documented in section 402g of the tax code. For 2015, that maximum is $18,000 for those under 50 years old, and an additional $6,000 “catch-up contribution” for those over 50 across all accounts.
What if you over-contribute to a 401K?
If you only have one 401K plan during a calendar year, it is very unlikely that you will ever make an excessive deferral, or over-contribute to your 401K. You don’t have to worry about calculating the precise dollar or percentage amount to perfectly nail that 401K maximum on your last paycheck of the year (or promptly cut off 401K contributions, if you max out sooner).
Your 401K plan administrator (the investment brokerage that houses your 401K account) will know what the maximum contribution is for the year and limit your contributions to that amount. If they don’t, contact them to make the correction immediately.
There is a second, much more likely scenario, that might lead you to over-contributing to a 401K: multiple 401K plans from two or more employers in a calendar year. There are two ways in which this could occur:
- You accidentally contribute a sum to multiple plans that is greater than the maximum annual 401K limit.
- You purposefully contribute a sum to multiple plans that is greater than the maximum annual 401K limit. 😉
Theoretically, you should tell your new employer how much you previously contributed to other 401K plans for the year when you start employment so that they can cap your contributions to not go over the annual maximum. However, that might not be the smartest move. In fact, if your new employer has a better 401K match, it can be a very costly mistake. Let me illustrate why through a painful personal lesson…
Back in June of 2007, I made the move to join my current employer. At the time, I was absolutely thrilled to learn that they offered 401K matching of 50% of my contribution, up to the IRS maximum (which was $15,500 at the time). Unfortunately, I had already contributed the maximum contribution for the year at my previous employer – who matched roughly $1,000 for the year. Little did I know that I’d be leaving my previous employer mid-year and that my new employer would have such an amazing (and superior) matching 401K benefit.
I thought to myself,
“Damn, in a way I have inadvertently punished myself for good behavior and missed out on almost $7,000 in additional matching funds from my new employer! If I had only known, I wouldn’t have contributed in the first place!”
What I know now that I didn’t know then, is that it didn’t have to be that way. I could have purposefully over-contributed against the IRS maximum by adding additional funds to my new 401K, and then withdrawn the funds from my previous employer’s lesser-matching 401K at the end of the year!
Not knowing this one simple 401K hack literally cost me $7,000 in free money. They say ignorance is bliss, but when it comes to personal finance, I wholeheartedly disagree. Hopefully, in sharing this story, I will prevent you from making the same ignorant mistake.
How to Correct an Over-Contribution to a 401K
There are a few steps that you need to follow or you could end up paying penalties to the IRS.
- Don’t roll over your old 401K. Keep the funds where they are until you have remedied.
- As soon as you get your W2’s from your new and previous employers, send a copy of both in to the administrator of the plan that has the lesser 401K match that you would like to withdraw funds from. The letter should state that you have made an excessive deferral and would like to withdraw $XX amount of contributed funds ASAP. Send this as soon as you get the W2’s – most administrators require receipt of this paperwork by March 1st for the previous calendar year’s contributions. Make copies of everything!
- Finish everything by the tax deadline (typically April 15) in order to avoid penalty from the IRS.
- Your administrator should send you a check for the withdrawn funds and any investment returns. They will also send you 1099-R forms for the contributions (calendar year contributed) and earnings (calendar year distributed), as they are considered income.
If you are considering doing this, also read up on the IRS documentation on 401K contributions over the limit. The following sections should be of particular interest:
Timely withdrawal of excess contributions by April 15
- Excess deferrals withdrawn by April 15 of the year following the year of deferral are taxable in the calendar year deferred.
- Earnings are taxable in the year they’re distributed.
- There is no 10% early distribution tax, no 20% withholding and no spousal consent requirement on amounts timely distributed.
Consequences of a late distribution (after April 15)
- Under IRC Section 401(a)(30), if the excess deferrals aren’t withdrawn by April 15, each affected plan of the employer is subject to disqualification and would need to go through EPCRS.
- Under EPCRS, these excess deferrals are still subject to double taxation; that is, they’re taxed both in the year contributed to and in the year distributed from the plan.
- These late distributions could also be subject to the 10% early distribution tax, 20% withholding and spousal consent requirements.
Definitely confirm everything with a tax advisor and your 401K administrator before making any moves.