Contributions Over the Limit
By Kaye A. Thomas
Current as of November 17, 2013
How to handle a situation where you go over the limit for contributions to a Roth 401k or similar account.
Most people don’t have to worry about contributing too much to their 401k or similar account. Companies maintaining these plans generally have procedures in place to prevent you from going over the applicable limits. An excess contribution is still possible, though, especially if you work for more than one employer in the same year.
Example: During the first six months of the year you contribute $2,000 per month to your 401k account. Then you take a job at another company, sign up for their 401k plan and contribute $2,000 per month to the new 401k account for the last six months of the year.
If you had stayed with the first employer, the 401k plan administrator almost surely would have cut off your contributions when you reached the applicable limit. The new employer isn’t responsible for knowing how much you contributed to the 401k at your previous employer, though. The company will follow your instructions, putting $2,000 per month into the account and bringing your total contributions for the year to $24,000, exceeding the dollar limit.
It’s your responsibility, not the company’s to make sure your contributions stay within this limit.
Correcting the excess
If you don’t correct an excess contribution, you’ll end up with double taxation: you’re taxed on that money in the year you earn it and also in the year you take the money out of your account. To avoid that result you have to take a corrective distribution by April 15 of the following year. The corrective distribution will include the dollar amount necessary to bring your contributions within the limit, plus any investment earnings on that extra money for the time it was in your account.
You can take the corrective distribution from any account. For example, you might start out contributing to a traditional account and later contribute to a Roth account. It might seem logical that the Roth account is where you have the excess, because that’s where you made the later contributions that put you over the limit. But you can choose to take the corrective distribution from the traditional account if that seems like better planning. Likewise, when two or more employers are involved, you can take the corrective distribution from the plan where you made the earlier contribution — if you can get the former employer to cooperate. The key is to get your total down to the limit with a distribution from some account by April 15.
If you don’t correct the excess
Some people don’t figure out they have excess contributions until it’s too late — or have trouble getting their employer to cooperate in making a corrective distribution. If you’re stuck with an uncorrected excess contribution, you’re going to pay tax twice on the same amount. Not exactly an elegant result, but that’s what the law says.
If your Roth contributions alone aren’t over the limit, the rules say any uncorrected excess is in your traditional contributions, even if they came earlier than your Roth contributions. In this situation you have to report the excess contribution as income on your tax return. Even though you paid tax on this amount, you don’t get to treat it as an after-tax contribution, and that means you’ll pay tax on this amount again when you withdraw it from your 401k account.
Example: Your limit for the year is $17,500. The first part of the year you worked for a company that offered only a traditional 401k and contributed $10,000. The second half of the year you worked for a different company and contributed $10,000 to a Roth 401k account.
As described earlier, you’re allowed to correct the excess from either account. If you fail to do so, the rules say the excess is in the traditional account.
Your W-2 from the first employer will show your income reduced by $10,000. The rules say you have to report an additional $2,500 of income for the year to eliminate your tax benefit from the excess contribution. Eventually you’ll withdraw this money from your 401k account (or a rollover account) and pay tax on the same amount again.
Excess Roth contributions. Suppose we change the facts above so you contributed to Roth accounts at both employers. Then you would have an uncorrected excess in your Roth contributions. When this happens, you already paid tax on the money once because there is no reduction in income when you contribute to a Roth account. To make sure you pay the piper, the rules put this excess amount in a special category. It’s going to be taxable when you take it out of your Roth 401k account, no matter what. In fact, the first dollars that come out of that account are taxable until you’ve eliminated the excess. What’s more, these dollars are not eligible for rollover. They’re just sitting there as a ticking tax bomb, waiting to go off.
In this situation you’ll also have to pay tax on any earnings generated by the excess deferral, even if you’re over 59½ and you’ve had the account more than five years.