Excess 401k plan contributions can easily become an issue for mobile employees and the companies who employ them. The IRS puts an annual cap on the number of contributions an employee can make to a 401(k) plan and contributions above that amount are referred to as excess 401k plan contributions. It is important for plan sponsors to keep excess 401k plan contributions in mind to make sure the plan remains in compliance. These errors should be avoided whenever possible, as fixing them is both time-consuming and costly.
Retirement plan sponsors and employees do not always consider excess 401k plan contributions in the context of a job change, but they should. Most 401k plans have stop gaps in place to alert employers and employees when the employee is in danger of making excess 401k plan contributions. However, excess 401k plan contributions still do occur from time to time.
To review, employees can contribute up to $19,000 to a 401(k) in 2019, per IRS limits. Individuals 50 and over can make additional catch-up contributions of up to $6,000. Excess 401k plan contributions can sometimes occur when employees change jobs during the year since they can easily end up participating in more than one employer’s plan. Chances are pretty good that an employee may not tell their new employer how much they contributed to their previous employer’s plan. As such, the new employer may not know when to “turn off” the employee’s deferrals when they’ve hit the annual IRS limit, according to David Mayes, President & Chief Investment Officer at Breaking Point Wealth Partners, writing in the Seacoastonline, a digital publication based in Portsmouth, NH.
Excess 401k plan contributions are messy and costly for both employers and employees. In the employee’s case, if the excess 401k plan contributions (deferrals) are not corrected in a timely manner, the employee’s income can potentially be taxed twice. The amount of the excess 401k plan contributions has to be added to the employee’s W-2 wages in the same year the excess 401k plan contribution was made. This effectively makes it as if the excess 401(k) plan contribution was made from after-tax dollars. That eliminates the tax-deferred advantage of contributing to a 401(k) for the employee. It also means the after-tax contribution doesn’t count as “basis,” in the employee’s 401(k) account. Thus, as noted in the article, the excess 401k plan contribution will be subject to ordinary income tax again when the employee withdraws it from the plan.
To illustrate the drawbacks of failing to catch excess contributions, Mayes provided the following real-world example in his article:
“… suppose Jane works for Plum Computer for half the year and contributes 15 percent of her $100,000 salary to its 401(k) plan. She then leaves Plum for a $150,000 salary at IQ Tech, one of Plum’s competitors. Jane wants to keep her retirement savings going at the same rate so sets her salary deferral election to the new plan at the same 15 percent. When she receives her W-2 forms, she notices she contributed $15,000 to Plum’s 401(k) and another $11,250 to the IQ Tech plan. Because the $19,000 salary deferral limit applies per individual, not per plan, Jane has made an excess contribution of $7,250 and must add this amount to the wages reported on her W-2s causing her to pay tax on money deferred to the 401(k)s.
- To fix the problem, she must immediately notify her current employer (before March 1) and request a distribution of the excess contribution and associated earnings to her before the April 15 tax filing deadline. If the excess deferral is withdrawn in time, Jane can avoid paying tax twice on these funds. The plan will send her a check for $7,250 plus earnings and she will receive a 1099-R the following year showing the withdrawal amounts. She will not need to include the $7,250 in her taxable income since it was already taxed on her prior year tax return. The earnings, however, will count as taxable income for the year in which they were distributed to her.
- If the deadline is missed, IRS rules require the funds remain in the plan until another triggering event occurs that allows participants to make withdrawals under the plan’s terms, or if the excess deferral must be withdrawn to prevent the plan from becoming disqualified under the Internal Revenue Code. If withdrawn later, the $7,250 will be added to income in the year of the withdrawal, resulting in double-taxation of this income.”
In short, it’s important for employers to be mindful of new hires’ 401(k) plan contributions to their previous employer’s plan vis a vis their deferrals to their new plan and IRS contribution limits. The bottom line: plan sponsors should ensure that excess 401k plan contributions are avoided wherever possible because the tax consequences to employees’ savings could be severe, and it is both costly and time-consuming to fix such errors.
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