Excess Retirement Plan Contributions Can Be Taxing

Article Highlights:

Excess IRA Contributions
Excess Contribution Penalty
Correcting Excess IRA Contributions
Applying the Excess to a Future Year
Excess 401(k) Contributions
Failing to Timely Correct 401(k) Excess Contributions

Some individuals financially struggle just to be able to make a nominal contribution to their tax-favored retirement plan, whether it be an IRA, 401(k) plan, or some form of self-employment retirement vehicle. Others sometimes over-contribute, whether intentionally or by accident. The following is a rundown of the tax consequences of over-contributing to tax-favored retirement plans.

Excess IRA Contributions – Any contribution to an IRA, either deductible or nondeductible (but not including rollovers), that is more than is allowed for the year is an excess contribution and is subject to a non-deductible penalty. For both 2019 and 2020, the maximum allowed IRA contribution is $6,000 ($7,000 for those age 50 and older). These limits apply to both traditional and Roth IRAs, or a combination of the two. After reaching age 70½, an individual is no longer allowed to contribute to a traditional IRA, and any amount contributed in the year when he or she turns 70½, or a later year, would be an excess contribution. In addition, IRA contributions are based on an individual’s earned income (income from working), and any amount contributed in excess of the earned income would also be considered an excess contribution.

Penalty – The excess contribution penalty is 6% of the sum of the excess amount contributed plus any earnings attributed to the excess contribution. The penalty continues to apply every year until the excess contribution is corrected.

Correcting an Excess Contribution – If the excess, including any earnings, is withdrawn by the extended income tax return due date (October 15, 2020, for 2019 returns) and no deduction was taken for the excess, here’s what will happen:

No penalty will be assessed on the excess or the earnings.
The earnings from the excess will be included as income for the year of the excess contribution.
A 10% premature distribution penalty will apply to the earnings if the taxpayer is under age 59½.

Example: Anne, age 40, had earned income of $45,000 in 2019, and she contributed $7,000 to her traditional IRA. Because she is under age 50, the maximum she is allowed to contribute to her IRA is $6,000. Her $7,000 contribution created an excess contribution of $1,000. Before the extended due date, she withdraws the $1,000 along with the $30 that the extra $1,000 had earned. On her 2019 return, she would only report a $6,000 contribution, include the $30 in income, and because she’s under age 59½, pay a 10% early withdrawal penalty of $3 on the taxable $30 earnings.

Other complications apply if the excess contribution is not corrected by the extended due date and depend on the circumstances.

Applying theExcess to Another Year – A taxpayer cannot apply the excess contribution to an earlier year but can apply the excess to a later year. While this allows a taxpayer to avoid a withdrawal from the IRA account, it does not avoid the 6% penalty on excess contributions that continues to be in force until the excess is completely applied to a future year’s IRA contribution.

Excess 401(k) and Other Elective Deferrals – It is not uncommon for individuals to have multiple employers, each with a 401(k) plan. This can create a situation in which the employee makes an excess elective deferral contribution. The maximum annual contribution for 2019 is $19,000 ($25,000 if age 50 and over).

The limit applies not only to each 401(k) plan to which the employee makes elective deferrals but also to the aggregate amount of all the elective deferrals made by the employee for the year to all plans that permit such contributions, including 401(k)s, self-employed plans (SEPs), tax-sheltered annuities (403(b) plans), and SIMPLE plans.

Example: Sam is a 45-year-old individual who participates in Employer Y's 401(k) plan. For January through July 2019, Sam deferred $12,800 into Y's 401(k) plan. Sam subsequently leaves his job with Employer Y and begins working for Employer Z. During the remainder of 2019, Sam defers an additional $6,500 under Z’s 401(k) plan. Sam’s 401(k) contributions for 2019 total $19,300. Since Sam is under age 50, Sam’s maximum allowable contribution for 2019 is $19,000, so he has $300 in excess contributions.

Correcting Excess 401(k) Contributions – After the close of the tax year but not later than April 15, the taxpayer may notify each plan to which he or she made 401(k) contributions. The notifications must also identify the extent, if any, to which the contribution consisted of designated Roth contributions. No later than April 15 after the close of the taxable year, the plans may distribute the excess and any earnings associated with the excess contribution to the taxpayer. Excess deferrals withdrawn by April 15 are taxable in the calendar year deferred, with earnings taxable in the year when they are distributed, and there’s no 10% early-distribution penalty.

Failing to Make the Correction – The results of not correcting an excess 401(k) contribution before April 15 of the subsequent year are as follows:

1. The excess is taxable in the year of the excess contribution (but not subject to the 10% premature distribution penalty if the taxpayer is under age 59½).
2. Whenever the excess is withdrawn, it becomes taxable again.

As you can see, making excess contributions to retirement plans can have some unpleasant tax ramifications. Please call this office if you have questions or need to correct an excess contribution.