The maximum amount of contribution to 401(k) is specified beforehand. However, there could still be circumstances where you could end up contributing above the limit. Saving more is a good idea but crossing the contribution limit isn't something you want to do. What happens if you contribute too much to 401(k)?
Launched in 1978, the 401(k) plan was designed by Congress to encourage people to save for retirement. One of the main benefits is the tax advantage. Now, 401(k) is the most popular employer-sponsored retirement plan in the U.S.
Types of 401(k) and what they offer
A 401(k) is a retirement savings plan that allows employees to deposit part of their salary directly into a long-term investment account. In some cases, the employer might match part or all of the employee’s contribution. Employees can choose the type of investment options among the ones provided by the employer. Many U.S. employers offer the plan. It's named after a section of the U.S. Internal Revenue Code.
The two basic types of 401(k) plans are traditional and Roth. The major difference is how they are taxed. While contributions to a traditional 401(k) are paid from the employee’s gross income, in Roth, the employee's pay after tax has been deducted from their incomes.
Contribution limits for 401(k)
The maximum amount that an employer and employee can contribute to the 401(k) plan gets adjusted periodically to reflect inflation. For 2021, the limit on the employee contribution is $19,500 per year for workers under age 50. For people over 50, an additional $6,500 is added as a catch-up contribution.
In case of matching employer contributions, or if employees elect to make additional after-tax contributions, the total employee/employer contribution for workers under 50 is limited to $58,000, or 100 percent of employee compensation, whichever is lower. For those 50 and over, the current limit is $64,500.
Scenarios where individuals might overcontribute
When you defer more to the 401(k) than the maximum allowed by the IRS, it's known as overcontribution. You could end up contributing more than the plan limit if you switched employers and retirement plans during the tax year. Another reason that could lead to excess contribution is if you're working two jobs with two retirement plans.
The contributions can’t be collectively higher than the limit since the limit is per person and not per plan. Also, if you end up getting a raise mid-year and you're contributing as a percentage of salary, you could overcontribute.
What to do if you overcontribute to 401(k)
If you realize that you have overcontributed, contact your employer or plan administrator as soon as possible. The plan administrator is required to return the excess funds to you and calculate and return additional earnings. They will reissue paperwork that corrects the 401(k) overcontribution.
The returned excess amount will be added to your total taxable wages for the previous year, so an amended W-2 will be issued. Your tax bill could rise relative to the amount of the excess 401(k) contribution. If the amount isn't paid back to you by April 15, you could be taxed twice on the amount that goes over the limit. Any income earned from the excess contribution will count on your tax bill due the following April.
In terms of excess contribution, it's important to consider that the IRS announces an increase in 401(k) contribution limits and the change is usually for the following year. The employer’s matching contributions won't push you above the wage deferral limit.