If you contributed too much to your 401k you may end up owing a penalty. Depending on when you realize that you have contributed too much, you may be able to reverse it. If you do it before the deadline you can avoid the penalty entirely.
In this article I’ll explain what you need to do if you still have time to correct it, and what you can expect if you don’t.
Of course, if you contributed too much to your 401k the glaring implication is that you have more money to save than what you can put into your 401k. The next question you’ll likely ask yourself is “Ok, if I can’t put this in my 401k what should I do with it?”. I’ll give you some suggestions there too.
Penalty on Excess Contributions
First, let’s address your current situation. The penalty on excess contributions to your 401k is 6%. If you don’t or can’t correct it in time you’ll owe 6% on the amount you contributed over the limit.
For a precise example, let’s take 2019. The contribution limit was $19,000. If you put in $22,000 then you are $3,000 over the limit. Your penalty applies to the $3,000 excess for a $180 penalty.
The penalty is assessed as an excise tax when you file your income tax for the year. Meaning, you won’t see it deducted from your 401k. It’ll be on your tax return.
Here’s the kicker… the penalty is recurring. As long as that excess $3,000 remains in your 401k the penalty will apply. Each year, the penalty reduces the excess contribution until it has been entirely removed. In this example, the penalty in the second year would be 6% of $2,820.
How to Correct an Over-Contribution
If you realize you’ve contributed to much to your 401k, you may can correct it in time to completely avoid the penalty. To do that, you need to have the excess contribution removed from your account by Aprill 15th of the following year. Remember this penalty is a tax so it coincides with the tax filing deadline.
Even if you don’t correct it in time to avoid the penalty the first time you’ll still want to correct it before the next year since the penalty is recurring.
To have the excess removed contact your HR department and let them know what happened. Even if you have an online login to your account you won’t be able to remove it yourself. They’ll have to do it for you. The money has to come out of the account before April 15th so make sure you do this ahead of time. It could take several weeks. This problem isn’t like wine. It’s not going to get better the longer it sits there.
You probably have your 401k set up to automatically invest any contributions. If so, that means your excess contribution could have earned additional money before you have a chance to take it out. You need to take out any earnings on the excess as well. Your plan administrator should be able to help you with the calculations. The important part is that you get the ball rolling.
How to Avoid Over-Contributing
If you did over-contribute, you’ll want to make sure that you don’t do it again next year. The best way to avoid over-contributing is to take note of the annual 401k limits and make sure your savings rate won’t put you over. Ideally, you would spread your contributions out evenly over the year. If you saw that you were about to go over, you could stop your contributions.
It gets a little more complicated if you switch jobs or have more than one job that has a 401k. The limit is a single annual limit for all accounts, so you have to coordinate every plan you have in a given year.
If you change jobs make sure you take into account any contributions you made into your old 401k. Plan your contributions going forward based on the remaining amount. For example, take the limit for 2020 which is $19,500. Let’s say you start the year in one job and while there you contribute a total of $12,000 to your 401k. If you switch jobs later in the year, you’ll only have $7,500 of the $19,500 limit remaining. You’ll want to set your contributions to total $7,500 going forward for the rest of the year.
Don’t forget to increase that by $6,500 if you are 50 or over.
What to do with Additional Savings
None of that really addresses the fact that you have the ability to save more than your 401k allows. So what can you do with the extra savings?
You can still open IRAs for both yourself and your spouse. Whether you get a tax deduction for the contribution depends on your income. The deduction phases out and eventually goes away completely as your income increases. You may be a good candidate for a backdoor Roth IRA as well.
However, even if you can’t deduct the contribution you can still benefit from the tax-deferral on your investments.