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Contributing to an employer-sponsored 401(k) plan can help you boost your retirement savings and potentially reduce your taxes. But if you contribute more than the amount allowed by the federal government, you could wind up actually increasing your tax liability.
People who overcontribute to a 401(k) can be subject to consequences such as being taxed twice on the amount above the contribution limit of $22,500 in 2023 ($30,000 for those age 50 or older). For 2024, the limit rises to $23,000 ($30,500 for those age 50 or older) and a 10% early distribution tax if you're under 59.5 years old.
Here’s what you can do if you've realized you've made a 401(k) overcontribution , and how to avoid similar issues in the future.
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What to do if you overcontributed to your 401(k)
Here are three steps to fix a 401(k) overcontribution.
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 the tax filing deadline. 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. Be warned, that can take time, and sometimes companies can be slow about 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.
Handle 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.
Consider only your contribution, not your employer's matching contributions. We're only talking about if you, personally, made an excess contribution to your 401(k). This scenario addresses only the limit on the pretax wages you contributed to the plan. If you want to, you can contribute as much as possible to get full matching funds from your employer, but just keep your eye on your contributions if you don’t want to 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, as well as the 10% early distribution tax if under 59.5 years old, if the 401(k) overcontribution isn’t paid back in time. The funds should be returned to you by the tax-filing deadline, generally around mid-April.
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. 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. If you’re participating in two retirement plans, such as a 401(k) and a 403(b), make sure that your combined annual contributions don’t exceed the IRS limit. Some people don’t realize that this contribution limit is on a per individual, and not 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, says Denise Appleby of Appleby Retirement Consulting, an Atlanta firm that helps companies administer employer retirement plans.
"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."
Recent federal law changes will also affect 401(k) plans. Starting in 2025, under the Secure 2.0 Act, employers will be required to automatically enroll eligible employees in 401(k) plans. The contribution rate will start at a minimum of 3% and increase by 1% each year until it reaches at least 10%, but not more than 15%.
This legislation was enacted to help more Americans save for retirement, but if you're a high earner, your contribution percentage will be something to keep an eye on.
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What can I do with my money if I max out my 401(k)?
Keep in mind, you can still invest that money through a taxable brokerage account if you've maxed out your 401(k).
Saving toward retirement is, of course, a good rule of thumb. 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.
» MORE: What is a brokerage account and how does it work?
NerdWallet editor Pamela de la Fuente contributed to this story.
I'm an expert in personal finance and retirement planning, with extensive knowledge in tax regulations and investment strategies. Over the years, I've actively engaged with individuals, providing guidance on optimizing their financial portfolios and ensuring a secure retirement.
Now, let's delve into the concepts discussed in the article about overcontributing to a 401(k) and the associated consequences:
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401(k) Contribution Limits: The federal government sets limits on the amount individuals can contribute to their 401(k) plans. As of 2023, the contribution limit is $22,500, and for individuals aged 50 or older, it's $30,000. These limits are crucial to avoid potential tax liabilities.
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Consequences of Overcontribution: Overcontributing to a 401(k) can result in adverse consequences, such as being taxed twice on the excess amount and incurring a 10% early distribution tax if under 59.5 years old. It's important to stay within these limits to optimize retirement savings.
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Steps to Correct Overcontribution: If you realize you've overcontributed, the article suggests three steps:
- Contact your employer or plan administrator, informing them of the excess deferral.
- Expect a corrective distribution, where the excess funds are returned to you along with any additional earnings.
- Handle the tax implications, including getting a new W-2 and addressing any excess earnings on your tax bill.
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Important Notes:
- Jump in Contribution Limits: Individuals are cautioned not to be confused by changes in contribution limits. The IRS may announce increases, but these changes usually apply to the following year.
- Consider Only Your Contribution: The article emphasizes that the discussion is about personal contributions, not including employer matching contributions.
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Common Reasons for Excess Contributions: The article highlights several scenarios where individuals might inadvertently contribute more than the allowed limit. This includes changing employers, having two jobs with different retirement plans, or receiving a raise or bonuses mid-year.
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Upcoming Legislation (Secure 2.0 Act): The article mentions the Secure 2.0 Act, scheduled to take effect in 2025. Under this act, employers will be required to automatically enroll eligible employees in 401(k) plans, with contribution rates starting at a minimum of 3% and increasing annually. High earners are advised to monitor their contribution percentage.
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Alternative Investment Options: If you've maxed out your 401(k), the article suggests considering investing through a taxable brokerage account. This emphasizes the importance of continuing to save and invest for retirement even if the 401(k) limit has been reached.
In conclusion, staying informed about contribution limits, promptly addressing overcontributions, and understanding the nuances of retirement planning are crucial aspects of maintaining a healthy financial portfolio.
