Saving to Invest
Over Contributed to Your 401k, IRA or Roth IRA? Correct Excess Contributions To Avoid a Tax Penalty
The article below shows what options you have if you mistakenly over contributed to your employer 401k plan or IRA.
Over Contributed to Employer Sponsored 401(k) Plan
Firstly, congratulations on having reached your annual maximum contribution. But over contributing to your 401k (or IRA plan as discussed below) subjects you to the potential of double taxation and/or a penalty. An excess deferral left in your 401k plan is taxed twice, once when contributed and again when distributed. In most cases, if you over contribute to your employer sponsored plan (normally administered by companies like Vanguard or Fidelity), your excess contributions are automatically blocked or changed to an after-tax status to avoid an IRS penalty (normally 10% of the excess amount).
The plan administrator will normally reactivate your pre-tax contributions at your most recently elected contribution rate effective the first pay period of the subsequent year. If you are not sure of how your plan administrator handles excess contributions/deferrals check your plan documents, company intranet (search for excess 401k contributions or payroll contributions) or contact your benefits or payroll department. Don t try and guess, find out for sure. You are entitled by law to get your excess deferral) returned to you from any of the plans that permit these distributions.
To avoid making excess pre-tax retirement contributions in the future ensure you calculate your limits across all plans (particularly if you change jobs during the year), pay attention to bonus 401k contributions and use simple math like dividing your contribution target by the number of paychecks you get in the year. Finally, make it a point to assess your contribution percentage and amount once or twice a year to ensure you are contributing the right amount.
If you discover a 401k over contribution at the end of the year when filing your taxes (i.e all the contributions have already been made in the prior calender year) you need to request a 401k refund check from your plan administrator and the then declare this as income in an amended or subsequent years tax return. Normally your plan administrator should report excess deferrals to you via form 1099-R. This can be a big hassle, so best to avoid the over contribution by some early planning and regular monitoring.
Even though the average IRA contribution is $3,798, many Americans are still contributing too much to their traditional IRA or Roth IRA account without realizing it. The combined limit for a traditional and/or Roth IRA accounts is $5,500 ($6500 if you are over 50). For married couples, the combined limit is $11,000 ($12,000 if only one of you is age 50 or older or $13,000 if both of you are age 50 or older). If you find that you have made excess contributions, you must remove them before year end or face a 6% penalty for excess contributions. Instead put your extra savings into a good high yield savings account (post tax) or quality dividend stocks.
Generally, an excess contribution is the amount contributed to all your traditional or Roth IRAs for the year that is more than the smaller of:
IRA maximum limit for annual contribution described above*, or
Your taxable compensation for the year. The taxable income (modified AGI) limit applies whether your contributions are deductible or nondeductible.
Contributions for the year you reach age 70½ and any later year are also excess contributions.
An excess contribution is generally the result of your contribution relative to your modified adjusted gross income, your spouse s contribution, your employer s matching contribution, SEP IRA contribution or an improper rollover contribution.
Tax Penalties on Excess IRA Contributions
In general you will be subject to a 6% penalty if excess contributions for a year are not withdrawn by the date your return for the year is due (including extensions).The penalty cannot be more than 6% of the combined value of all your IRAs as of the end of your tax year. You must also pay the 6% tax penalty each year on excess amounts that remain in your traditional IRA at the end of your tax year.
For example, suppose you made a $3,000 annual contribution to a Roth IRA in 2007, then got a larger bonus than you expected and found that your permitted contribution was only $1,800. Your excess contribution was $1,200. If you didn t correct the excess contribution for 2007, you had to pay $72 excess contribution tax (6% of $1,200). And if you left the problem uncorrected beyond the end of 2008, you owe another $72. You ll continue to owe this tax each year until you correct the excess contribution.
Corrective Action to resolve Excess IRA contributions
There are several corrective actions you can take to avoid the 6% penalty, if you ve made an improper contribution to an IRA. This includes:
- Withdraw the excess contribution and any associated earnings. According to the IRS, any contribution that is withdrawn on or before the due date (including extensions) for filing your tax return for the year is treated as an amount not contributed. This provision only applies if earnings on the IRA contributions are also withdrawn. The earnings are considered earned and received in the year the excess contribution was made.
- The other is to re-designate your Roth IRA as a regular IRA. This “moves” or reclassifies the excess Roth IRA contributions as a less restrictive traditional IRA contribution, assuming you qualify for a traditional IRA. This will only provide effective relief for the over contribution in some cases.
- Applying excess contributions to a subsequent year. If contributions to your Roth IRA for a year were more than the limit, you can apply the excess contribution in one year to a later year if the contributions for that later year are less than the maximum allowed for that year. Though you may still be subject to penalties for the years in which you over contributed.
Whatever the reason for your excess IRA and/or Roth IRA contribution, a penalty tax of 6% will apply if you don t take action to correct an excess contribution. So check online or via a phone call with your plan administrator (e.g. Vanguard, Fidelity) to see how much you are on target to contribute, and take corrective action sooner than later. If you are not sure what to do then I strongly recommend you consult with a tax professional or use automated tax software to help with your tax filing.
*Note. Your IRA maximum limit may be increased to $8,000 if you participated in a 401(k) plan maintained by an employer who went into bankruptcy in an earlier year.