What happens if you over contribute to a 401(k) concerning the IRS?

Factual Questions
1

My friend changed jobs. After the wait period, he wants to continue to contribute to his 401(k) with the new company. He said he only has $3K left he can contribute for 2015 according to the IRS limit. But the new company wouldn’t allow him to start to contribute until 11/1/2015 and they only allow employees to contribute by percentage, you can’t select a dollar amount, and they have no way to do a one-time contribution of the $3K for 2015. They also aren’t exact with if the start and stops will take 1 or 2 pay periods.

I never heard of such restrictions before. I have always been able to do the 401(k) either by percentage or a dollar amount, and they allowed one-time contributions in a dollar amount.

So we were talking and I said, “What happens if you go over the limit?” My friend said he didn’t know, he said he’s just expecting it to be a tax mess but doesn’t know the specifics. He’s considering either just putting in a very low percentage just to get something of the $3K left to contribute or just skip it and forget about the $3K for 2015.

So what might happen if you over contribute to your 401(k) with respect to the IRS? Do they impose a fine? Do you somehow take the money out in another tax year and pay tax on it? Do you have to amend tax returns? The big question, is this worth it for “rescue” the ability to contribute $3K for 2015?

2

I go over every year, and in my 401k contributions over the limit are tracked separately as after tax dollars. After retiring I can roll those dollars over to a Roth IRA, while pre-tax contributions roll over to a conventional IRA.

Because it’s one employer and one plan administrator in my case they keep track. With two separate employers and administrators your friend will probably have to keep track himself. The employer won’t know when he’s gone over the limit, so he probably won’t have the right tax deducted from his paycheck after he’s over the limit, so that will come due when he files.

3

Many years ago, I contributed too much to my 401k. I called the IRS and asked how to handle it. The very helpful person I spoke to wasn’t sure - took my number and called me back later that day.

The answer I was given was to fill out a simple form and get the extra “wiithdrawn”…they sent me a check for the amount of the overage.

Other options may be available, and possibly more appropriate for your friend.

4

The answer is basically whatever he wants to happen. He can leave it in there and the company managing his account will have to track it separately till it leaves the account (yes for tax purposes) and so will very strongly encourage him not to do this since it is a huge pita, mostly for them.

He can take the money back out and put it somewhere else with no issues as it was an over payment into the account. If this money was after tax money, no problem. Pre tax money will, of course, have to have the taxes paid on it.

These are the first two and (to me)most obvious options, (over)simplified. Your mileage will vary according to any local state financial laws, company policies and plan policies of course.

Edward, either your friend doesn’t have all or is misunderstanding some of the info, or he just needs to not have a 401(k) through this company. What you have described, to me, sounds just goofy as hell.

5

I think it depends on your 401(k) plan. In my plan, money deposited in the plan is not necessarily “before tax” and they will keep track accordingly. Typically, since the plan knows exactly what your salary is, I would imagine that they simply would not accept money in excess of the amount permitted. However if a plan were poorly administered, I can imagine this happening. If you contribute more than the permitted amount to an IRA, you pay a penalty and you must withdraw the original overage plus the amount earned from that overage. This also happens on the other end when you attain age 70 1/2 and need to start taking a Minimum Distribution (if you don’t take the required minimum).

6

When it happened to me, it was because I changed jobs, and miscalculated the percentage I needed for the new job. The plan had no way of knowing how much I had contributed at my previous position, so they couldn’t account for it.

Since the OP starts with a similar scenario, I wouldn’t expect the friend’s position to be much different from the one I was in.

7

Let’s not confuse the issue by talking about IRAs. The rules are different between 401Ks & IRAs. Yes, there are some gross similarities, but the differences are significant.

IME, Post #4 nailed it. This isn’t a crisis. 401Ks are designed to be able to have excess non-tax advantaged contributions in them in addition to the more common tax-advantaged contributions.

The OP’s friend needs to decide what he wants done with any excess and then talk to the 401K administrator to make that happen. The IRS itself has nothing to do with this. There are no forms, no penalties, etc.

The fact he has two 401Ks from two administrators means he’s going to have to manage this carefully and explain to the second one about the amounts already contributed to the first one.

8

Did you need to involve the company’s 401(k) plan administrator to handle this?

9

No, that’s wrong. Many 401k plans do not allow excess non tax advantaged contributions because that entails additional record keeping responsibilities. If the second plan doesn’t allow after tax contributions he may be able to put the excess contributions in a Roth 401k, but that’s not guaranteed to be available either. In my plan both the after tax and Roth options are available, but I’ve seen data that fewer than half of the plans have these options available.

10

I believe so. I think I had to fill out a form giving the amount I wanted returned. But it was 10 years ago…memories are difficult.

11

The 2015 before-tax 401(k) contribution limit is $18,000 ($24,000 for individuals over 50) per taxpayer. If you have more than one employer during the year, this limit applies to the sum of the before-tax contributions made to all employers’ plans.

The Section 415©(1)(A) limit is $53,000 per plan (not per taxpayer). The $53,000 limit includes all before-tax contributions, after-tax contributions, employer contributions, etc. If you have more than one employer, this limit applies separately to each employer.

“Before-tax” contributions are deductions from your salary on which you will not pay taxes. However, you will pay taxes when you withdraw them from the plan (typically when you retire). “After-tax” contributions are deductions from your salary for which you get no tax deduction and on which you will pay no taxes when you withdraw them.

Very few employers allow after-tax contributions.

When you only have one employer during a given year, unless the employer screws up royally, there is no way you will exceed either limit. Some employers who allow after-tax contributions will automatically switch the contributions from before-tax to after-tax as soon as the employee reaches the annual before-tax limit. Other employers will just stop taking contributions.

The problem arises when you have more than one employer during a given year. Employers are not require to keep track of what you have contributed to a different employer’s plan or to coordinate their plans, so an employee may end up exceeding the $18,000 before-tax limit.

Let’s say an employee under age 50 has two employers and makes a $10,000 before-tax contribution to each employer’s plan in the same year. The employee has contributed a total of $20,000 which is $2,000 over the limit.

Option 1: The employee does nothing. The employee will receive two different W-2s (because he had two employers) each showing that his taxable pay was reduced by $10,000. When the employee fills out his Form 1040, he will have to add $2000 to the total on Line 7 and pay taxes on the $2000. Later (typically when he retires) he will STILL have to pay taxes on the extra $2000 when he withdraws it from the plan. In other words, he will get taxed twice on the $2000.

Option 2: The employee may request either employer to make a $2000 corrective distribution. Neither employer is required to grant the request. But if a corrective distribution is made, the employer must distribute the $2000 plus any earnings on the $2000. The $2000 and the earnings will be taxable. The corrective distribution must be completed by April 15th of the following year. A common mistake that people make is that they realize the problem after April 15th and demand a corrective distribution then. If you take the distribution after April 15th, you will both pay taxes on the over-contribution and on the distribution. If you cannot complete the corrective distribution by April 15th, just leave the money in your 401(k).

Option 3: You can prevent the over-contribution from even happening by requesting the second employer to take after-tax contributions instead of before-tax contributions, if the employer allows it.
Now you may read in many places in the net, that there is an annual penalty on over-contributions until you withdraw them. There is NOT. The people who write this are confusing 401(k) plans with IRA plans. There is a 6% annual over-contribution penalty for IRAs. This penalty does not apply to a 401(k).

12

The sum of your Roth 401(k) and before-tax contributions cannot exceed the annual limit ($18,000 in 2015 for individuals under 50). Using a Roth 401(k) won’t help.

13

Thanks, I knew there was a reason I went to making after tax contributions after the limit instead of the Roth. I plan for it to happen the same month I stop making Social Security contributions to the OASDI program, so the tax relief from that mitigates the extra tax from losing the 401k deduction.

14

So my friend decided to talk directly the company’s 401(k) Plan Administrator to do a one-time $3K contribution for 2015. The plan administrator to our surprise said it wasn’t possible to do this, the plan was only set-up by the company to accommodate a percentage being started and stopped within 1 or 2 pay periods.

So he said he’s going to figure out a low enough percentage so that for the rest of the year he is way below the $3K to avoid it going over the IRS limit for 2015.

I suggested he intentionally go over the $3K, and then tell them he is over and they have to correct it. But he said he doesn’t have the confidence the plan administrator would handle a task like this, and if they can’t, he would get stuck with paying tax on this money twice if they don’t return the money and interest (if any) to him by April of 2016. He also said they might just back out all the money and return it to him, since at this point he considered their 401(k) plan and handling to be pretty lame.

It seems insane, he can’t just specify the amount he has already contributed from another plan so that this plan won’t go over it, but he said his general feeling is that the company doesn’t give a damn about the 401(k) since they don’t contribute any matching to it anyway and is only providing it the cheapest way they know how. So this inflexibility might very well be the reason for this.

Certainly not a deal breaker in changing jobs, but there is a concern to be learned here. If possible, finish up your 401(k) contributions if it’s feasible before you change to another company, because they might not be accommodating.

If this were merely a tax related situation, he would handle it on his personal tax return, but it won’t matter if the money over the limit isn’t properly returned to him from the 401(k) plan.

In some 401(k) plans I have been in myself, I tried to do the max, only to have them return money to me at the end of the year because not enough people contributed to the plan so even though it was below the IRS limit, I was forced to accept the return of the funds and pay tax on them.

I should repeat, this is all for pre-tax my friend is concerned about.

15

The IRS will be able to detect if he has over-contributed. There’s a box on your W2 that is designated for 401k contributions. The IRS will add the amounts from his two different company W2’s and if he exceeds the amount permitted annually, they will know if you exceeded.

https://www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/Retirement-Topics-What-Happens-When-an-Employee-has-Elective-Deferrals-in-Excess-of-the-Limits%3F

16

Why not? Since the Roth contributions are not tax deferred the IRS shouldn’t care, right?

17

The Roth is charged no taxes on any gains or income. Of course the IRS cares.

18

The answer to any “why” question on taxes is ultimately “Because Congress said so. Perhaps unwittingly, but that’s what they said. So that’s what we do.”

In a bit more detail. …

A Roth-style account (IRA or 401K) represents the gov’t foregoing future tax revenue. They thought it wise to put an upper limit on that future tax forgiveness so there’d be something left for them to tax in 2050 or whenever. So they did.

19

Oh, duh. Thanks.

20

Thanks for the link.

There is a part of this I don’t understand how it works. Say the over-contribution was done in 2015 for $3K. This amount is returned to the employee with any loss or gain on the investment in 2016 and I assume with taxes withheld, all done before the April income tax filing deadline.

OK, what about the W2 from 2015? Because if the IRS adds up the contributed amounts from the two employers for 2015 it is going to total more than the limit by the IRS for 401(k) contributions by $3K. What happens? Does the IRS send the tax payer a letter and that person writes a letter stating the money was returned and taxed in 2016?