What If You Overcontribute to a 401(k) or IRA?

We recently got this interesting question from a reader named Jeff:

I know the IRS limit for 401k contributions. . . . What I want to know is what actually happens if I contribute more than that, say $20k? Do I get a stiff penalty?  Do I go to 401k jail?  Is this handled like a Roth IRA?

Jeff is right to be concerned about contributing more than the IRS limits in a given year.

Most of us won’t have to worry about contributing more than the annual limit. Even if you have enough money available to over-contribute to a 401(k), your plan administrator will likely keep you from contributing too much in one year.

This is a slightly more common problem, though, if you switch jobs during the year, or if you work two jobs and have a 401(k) with both. In this case, you’ve got to be extra careful that you work with plan administrators to ensure that your total 401(k) plan contributions for the year don’t exceed the contribution limits.

Besides communicating with your employer if you’re in one of these situations, the best thing you can do is to stay on top of your 401(k) contributions. The sooner you notice an overcontribution mistake, the sooner you can fix the problem.

How to Fix an Overcontribution

According to the IRS, if you overcontribute to your 401(k), you’ll have until April 15 of the next year to correct the problem. The IRS advises that employees should contact their plan’s administrator to fix the problem:

The employee should notify the plan and ask that the difference (called an excess deferral) be paid out of any of the plans that permit these distributions. The plan must then pay the employee that amount by April 15 of the following year (or an earlier date specified in the plan).

The excess amount taken out is then included in your gross income for the year in which it was contributed to the 401k, according to the IRS. The interest earned on the amount that is withdrawn from the 401k, however, is taxable in the year in which it was taken out.

So, let’s say you accidentally contributed $500 over the limit between two employer plans in 2016. You’d have until April 15, 2017 to work with your plan administrators and withdraw the extra money plus any interest that money earned. The $500 will be included in your gross income for the year in which it was contributed to the 401k (which was 2016). The interest earned will be added to your taxable income for the year in which it was taken out — depending when you corrected the situation, this would either be 2016 or 2017.

It doesn’t matter how much you contribute over the limit. The same rules apply. It’s just that the more you overcontribute, the bigger your tax bill will be.

Because of the slow-moving nature of some 401(k) plans, it’s important to get your overcontribution correction in gear as soon as possible. It’s best if you initiate the withdrawal by March 1.

This means that you need to stay on top of your contributions for the previous year. Check them in January or February, just to ensure that you don’t miss any over-contributions.

Consequences After April 15

In many cases, individuals don’t notice that they’ve over-contributed to a 401(k) plan. So, what happens if you contribute too much but don’t notice it before April 15?

In this case, the excess contribution is effectively taxed twice. You’ll pay tax on the excess in the year it was contributed to the 401k (even though it wasn’t taken out). You’ll also pay tax on the amount once it is withdrawn from the retirement account. Here’s the explanation from the IRS:

Excess not withdrawn by April 15. If the employee does not take out the excess deferral by April 15, the excess, though taxable in the year of deferral, is not included in the employee’s cost basis in figuring the taxable amount of any eventual benefits or distributions under the plan. In effect, an excess deferral left in the plan is taxed twice, once when contributed and again when distributed. Also, if the entire deferral is allowed to stay in the plan, the plan may not be a qualified plan.

Double-taxation is never a good thing. Depending on how much you overcontributed, this could make for some hefty financial consequences.

Employer Contributions Don’t Count

One thing to note here is that employer contributions do not count against your 401(k) contribution limit. So, if your employer has a matching program, you can contribute up to your 401k limit plus the employers’ matching amount.

IRAs are Similar

If you have an IRA, you’re also subject to contribution limits that can change from year to year. If you contribute more, you have until April 15 to remedy the situation. According to Vanguard, you can simply withdraw the excess contributions and their earnings before tax-filing deadline.

But what if you discover the problem after you file your return? According to Vanguard, you once again have one of two options:

• Remove the excess within 6 months and file an amended return by October 15; or
• Reduce next year’s contributions by the amount of the excess. For example, if your limit is $5,500 and you exceed it by $1,500 in the current year, you can offset the excess by limiting your contributions to $4,000 the following year.

Note: If you choose the “carry forward” option, you’ll have to pay a 6% penalty tax until the excess is absorbed or corrected.

Also, if you contributed to both a Roth and traditional IRA in the same year and combined exceeded your contribution limit, the IRS requires you to remove the excess from the Roth IRA first, according to Vanguard.

You’ll pay a 6 percent tax penalty on the money for each year it remains in your account, so you’ll want to get any excess contributions fixed immediately.

Related: Current IRA Contribution Limits by Year

If You Have More to Contribute

I suspect part of the reason Jeff asked his question is that he would like to save more for retirement in a given year than just the contribution limit. In this case, it’s best to have multiple retirement plans. Be sure to follow the rules closely for each plan, though.

For example, you might max out your 401k and open a tax deductible or Roth IRA (assuming your income doesn’t disqualify you). He might also consider a high deductible health insurance plan that qualifies for a Health Spending Account. HSAs can be a great way to save for retirement.

Related: How an HSA can help you save for retirement

Final Thoughts

If you’d like to contribute much more to your retirement accounts this year than the limits allow, talk with an investment professional. They will advise you about how best to allocate your money. You’ll want to get the most bang for your buck, without running awry of the IRS. And if you did accidentally overcontribute, take steps now to fix the problem. There still may be time left to avoid a penalty.

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