Buzz
When you begin saving for retirement, you may believe hitting the max annual contribution feels far off. But your financial situation might have changed, and now you’re closer to the $19,500 limit for a 401(k) or $6,000 for an IRA than you thought.
You might be tempted to contribute just a bit more. But hold up. Saving for retirement is like competing on The Price is Right: getting as close as you can without surpassing the limit.
Curious about what happens if you go over? (Here’s a hint: You’ll end up losing part of that extra contribution.)
Generally, exceeding contribution limits for retirement accounts doesn’t happen often. If you only have one retirement account, your risk is low because the company managing your plan monitors your contributions. However, if your financial situation is more complex and you hold multiple retirement accounts, you might need to stay more vigilant.
"The primary reason this happens is when someone switches jobs mid-year and ends up with two retirement accounts, which are not being tracked against the annual limit," explained Mike Savage, CPA and founder of 1-800Accountant. "If they only have one account, the financial institution typically notifies them of any excess contributions," he added.
You might also find yourself in this situation if you hit an income cap for your retirement account, like with a Roth IRA. If you fully fund your Roth IRA but are also eligible for an employer-sponsored plan, things can get tricky. As Amin Dabit, director of advisory services at Personal Capital, noted, "Most people who face excess contributions struggle because they can’t predict where their income will stand at year’s end."
If you exceed the contribution limit for your retirement account, the IRS won’t let it slide. You’ll need to remove the excess funds quickly, or else you’ll face an excise tax penalty of 6%.
You can avoid the 6% penalty if you remove the excess contribution before filing your taxes. However, you’ll still have to report it as income (which means it’ll be taxed), and you’ll likely face a 10% penalty for early withdrawal from your retirement account.
You might be tempted to leave the money in your account to avoid the 10% penalty, choosing the 6% penalty instead. However, that 6% doesn’t just disappear if you ignore it. "The IRS will charge a 6% excise tax penalty every year the excess stays in the account," explained Dabit.
If your retirement account is through your employer, you’ll need to ask them to return the "excess deferral" to you, along with any earnings on it, according to Caleb Silver, editor in chief of Investopedia. If you’ve already received a W-2 from your company, they’ll need to issue an amended one.
You can also amend your tax return to avoid the penalty if you remove the excess and refile by the October extension deadline.
"Be mindful of your earned income, modified adjusted gross income, and the annual contribution limits," Silver advised. "Keep track of what you’ve already contributed for the year, and make sure to allocate contributions made between January 1 and April 15 to the correct tax year."
If you expect an unusually high income next year, such as a raise or bonus you want to save for retirement, you can contribute toward last year’s limit now to avoid an issue later. "One of the best ways to prevent over-contributing is to consult a tax advisor and make a contribution for the previous year while filing your taxes," Dabit recommended.
