What Is an Overcontribution?
An overcontribution is any voluntary contribution to a tax-deductible retirement plan that exceeds the maximum allowed contribution for a given period, as determined by the retirement plan's registrar or the Internal Revenue Service.
Overcontributing to a 401(k), for example, is a problem faced by few retirees, as under-contributions or no contributions happen more frequently. As of 2019, the IRS allows employees to defer up to $19,000 from their pay each year. There is also an allowed catch-up contribution for those age 50 and older, which is an additional $6,000 a year, raising the total annual limit to $25,000. According to the IRS, those limits rise to $19,500, $6,500, and $26,000 in 2020.
Of course, double these amounts for married couples who each work. If both partners are age 50 or more, each can max out their 401(k) contributions for a combined annual contribution limit of $50,000 for 2019 and $52,000 for 2020. Only above this amount do they face any overcontribution.
Notably, the limits only apply to payroll deductions. Any matches from employers, for example, do not count toward overcontributions.
If the limit still is breached, employees should notify their respective company or plan administrator early the following the year after the overcontribution occurred. It’s up to the plan administrator to return any excess payments to employees, as well as any earnings on the excess contributions.
Sending this notification as early as possible provides employers enough time to do the necessary paperwork. This typically includes adjusting any contributions that came out of employees’ checks on a pre-tax basis and counting them as wages on employees’ W-2 forms. This allows employees enough time to issue new forms before the annual tax-filing deadline.
Similarly, individual retirement accounts (IRAs) also have contribution limits. In 2018, the total contribution limit for Roth and traditional IRAs combined was $5,500 for those under age 50, and $6,500 for those 50 and older.
Dangers of Overcontribution
It’s important to correct overcontributions quickly. Otherwise, tax trouble often ensues. If the excess amount is not returned to affected employees in enough time to file taxes, employees run the risk of double taxation. That is, they could pay taxes in the year the excess occurred, and still need to pay the following year, as well.
To avoid double-taxation, some employees can file an amended return with the excess contribution taken out, plus any related earnings from the overcontribution. This must be done by the tax-extension deadline, however.
Overcontributions to IRAs are a bit easier to correct, but still result in penalties. Employees can leave their accounts alone and designate any overcontribution toward next-year’s limit. A 6% penalty applies per year on any excess. Of course, any individual contributions must be adjusted the going forward to keep from again creating an overcontribution the following year.