Over Contributing to Your 401K Might Not Be as Beneficial as You Think

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:

  1. You switched jobs: If you left a job that offered a retirement plan and your new company also has a retirement plan, you might have two separate 401(k) accounts. It’s possible to start a new job and leave your old 401(k) plan behind and focus on maxing out the 401K at your new job, forgetting that you already made contributions to your old 401(k).
  2. You have multiple jobs: If you have a few different jobs that offer this benefit, you might not be able to keep up with all your plans. It’s possible that you may over contribute if you don’t keep track of each of them carefully.
  3. You received a raise or a bonus: If you have set up your contributions to go automatically into your 401K, any traditional deductions such as taxes are withdrawn like normal; therefore, receiving a raise or a bonus might put you over the contribution limit.

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:

  1. Contact your Employer or Plan Administrator: Notify your plan administrator that you’ve made an “excess deferral” (the lingo is very important). 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 over contribution. For example, if in 2019 you contributed $20,000 to your 401(k), you need to be paid back $1,000 in excess deferral. That amount needs to be paid to you before April 15. That process takes time, and sometimes companies can move slowly doing this.
  2. Get an amended W-2 and pay taxes: Since the returned excess contribution will be added to your total taxable wages for the previous year, an amended W-2 will be issued. Your tax bill will rise (or your refund will decrease) relative to the amount of the excess 401(k) contribution.
  • Handling excess earnings: Any income earned from the excess contribution will count on your tax bill for the following year. You’ll receive a Form 1099-R at the end of the tax year in which the earnings were paid back to you.

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.

Check the background of this investment professional on FINRA’s BrokerCheck

Advisory services offered through EWG Elevate, Inc. dba Protection Point Advisors.

This represents a partial list of clients. They have not been compensated and were not selected based on duration, performance, account size.