If you’ve discovered you overcontributed to your employer-sponsored 401(k) plan — first of all, congrats on maxing out tax-free contributions to your retirement savings. That habit will pay off down the line.
But the clock is ticking to notify your plan administrator and correct the problem before April 15. If you don't act, the worst-case scenario is that you may be taxed twice on the amount above the contribution limit of $19,500 for 2020 and 2021 ($26,000 for those age 50 or older).
"Who wants to pay taxes on any amount twice, right?" says Denise Appleby of Appleby Retirement Consulting, an Atlanta firm that helps companies administer employer retirement plans.
Here’s what you should do to correct the problem, and how to avoid in the future.
Here’s what to do before filing your taxes
Contact your employer or plan administrator. Some lingo can be helpful here: Tell your plan administrator you’ve made an "excess deferral." For example, if you overcontributed by $1,000, that amount needs to be paid to you before April 15.
The plan administrator is required to return the excess funds to you — as a "corrective distribution" — plus calculate and return additional earnings (if any) and reissue paperwork that corrects the 401(k) overcontribution. "That takes time, and sometimes companies can move slowly doing this," Appleby says.
Denise Appleby, Appleby Retirement Consulting
Correcting an excess contribution takes time, and companies can move slowly doing this.”
Get a new W-2 and pay taxes. The returned excess contribution will be added to your total taxable wages for the previous year, so an amended W-2 will be issued. Your tax bill will rise (or your refund will shrink) relative to the amount of the excess 401(k) contribution.
Handling excess earnings. Any income earned from the excess contribution will count on your tax bill, which is due the following April. You’ll receive a Form 1099-R at the end of the tax year in which the earnings were paid back to you.
Two important notes
Don’t be confused by a jump in contribution limits. The IRS often announces an increase in 401(k) contribution limits, but the change is typically for the following year. Be sure to read the details of any contribution increase to make sure you understand how it applies to you.
This isn't about your employer's matching contributions. This scenario addresses only the limit on the pretax wages you contributed to the plan. Think about contributing as much as possible to get full matching funds from your employer, but just make sure your contributions don’t exceed the limit.
Dealing with excess 401(k) contributions after Tax Day
The bad news. You’ll end up paying taxes twice on the amount over the limit if the 401(k) overcontribution isn’t paid back to you by April 15.
You’ll be taxed first in the year you overcontributed, and again in the year the correction occurs, Appleby says.
Common reasons for excess 401(k) contributions
Here are some scenarios in which excess contributions are more likely to happen:
You switched employers and retirement plans during the tax year. "This is probably the most common reason," Appleby says. "And you’ve given too much to each plan." Make sure your new provider is aware of the year-to-date balance of your contributions to your old retirement plan. And consider rolling over 401(k) accounts from previous employers into your new plan or an individual retirement account.
You have two jobs with two retirement plans. "There are so many people now who are working two jobs," Appleby says. It’s important to remember that contributions to separate retirement plans like a 401(k) and 403(b) can’t collectively be higher than the limit. "Plan participants often don’t realize the limit is on a per individual basis, not a per plan basis," Appleby says. "And as a result they contribute the maximum amount to each plan."
If you're enrolled in a 457(b) retirement plan, that has a different contribution limit that may be higher.
Denise Appleby, Appleby Retirement Consulting
Plan participants often don’t realize the contribution limit is on a per individual basis, not a per plan basis.”
You got a raise or bonuses during the tax year. Lots of people set and forget their automatic contribution levels as a percentage of their income to get the full matching dollars from their employer. That’s smart. That’s free money.
But, say, your smarts also led to a promotion with a salary bump or bonus. That’s where the problem can occur, Appleby says.
"You might say, I’m making a salary contribution of 10% — take 10% out of my paycheck every month," she says. "And then you get this big fat raise in the middle of the year. That causes this 10% to be more as well."
Saving as much as you can toward retirement is, of course, a good idea. Crossing the line into excess contributions may be a pain, but any penalty will be slight compared with the long-term benefits of retirement savings. And keep in mind you can still invest that money through a taxable brokerage account.