Exceeding the contribution limit on a 401K is not a common occurrence; however, there are employees who are over contributing to their 401K(s); it is important to keep in mind that exceeding the contribution limits on your 401K might not be as beneficial as you think. Let’s begin by mentioning that the contribution limit for employees who participate in 401(k), 403(b), most 457 plans, and the federal government’s Thrift Savings Plan has been increased from $19,000 to $19,500. The catch-up contribution limit for employees aged 50 and over who participate in these plans has increased from $6,000 to $6,500.
Many people wonder if it is even possible to exceed the contribution limit on a 401K, and the answer is yes! Here are some of the reasons why people over contribute to their 401K:
Since there is a maximum dollar amount you can defer from your income on 401K contributions, generally, once you have reached that limit, your payroll deductions will cease and so will your employer match (if any). If you’ve discovered you over contributed to your employer-sponsored 401(k) plan, first of all, congratulations on maxing out tax-free contributions to your retirement savings. That habit will pay off down the line. However, it is important to amend the excess of contributions (preferably before filing your taxes) in order to avoid tax liabilities. Here are a few steps to follow:
If you are dealing with the excess contribution after tax day, you will be taxed twice on the excess contribution. You’ll be taxed first in the year you over contributed, and again in the year the correction occurs.
Additionally, it is important for you to know that you might end up losing money on employer contributions if you reach your contribution limit too soon. For example, if your income is $150,000/year, or $12,500/month and your employer offers a 5% match, and in order to contribute as much as you can to the plan as fast as you can you set up a 15% contribution. Each month, $1,875 will be deducted from your paycheck (15% of $12,500) and your employer will match $625 (5% of $12,500) for a total contribution of $2,500 a month ($1,875 + $625). After six months, you have contributed $11,250 (6 X $1,875) and your employer has added $3,750 (6 X $625). However, if you continue on this path, you will reach $18,750 worth of contribution in October (10 X $1,875) and will only be able to contribute the remaining $750 in November ($19,500 – $18,750). So, your contribution for December will be zero. And, since your employer only makes contributions when you do, their deposit will be zero as well. By funding your 401K too soon, you will lose one month of employer match, or $625.
How to avoid exceeding the contribution limit on your 401K: Simply divide the maximum dollar contribution of $19,500 by your annual salary and contribute the resulting percentage of your pay. So, in the example above, you would set up your contribution amount at 13% ($19,500 divided by $150,000 = 0.13 or 13%). Contributing 13% of your pay for 12 months will earn you more employer match than contributing 15% of your pay will for 10 months. Keep in mind that should revise your contribution percentage in any year that your income changes or the annual 401(k) dollar limit changes.
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