When it comes to saving for retirement, you’ve likely heard advice about maxing out your contributions in your 401(k), 403(b) or an individual retirement account (IRA). After all, retirement accounts come with some powerful benefits, so it makes sense to want to take full advantage if you can.
But what happens if you inadvertently contribute too much to a tax-advantaged account?
If you don’t withdraw the excess amount (and any earnings) before you file taxes for the year, you’ll end up paying 6 percent of the excessive contribution as a tax penalty every year until you correct the issue.
Below, we look at contribution limits, why over-contributions happen, and the steps you can take to deal with this issue.
2021 and 2022 retirement account contribution limits
Let’s begin by addressing the IRS limits on contributions and benefits. For tax years 2020 and 2021, you could contribute up to $19,500 (or $26,000 if you’re 50 or older) to Roth and Traditional 401(k)s, 403(b) and 457(b) accounts. For Roth and Traditional IRA accounts, you could put in up to $6,000 — or $7,000 if you’re 50 or older.
For tax year 2022, the contribution limit for 401(k)s, 403(b)s and 457(b)s increases to $20,500 (or $27,000 if you are 50 or older).
While there is no income limit to contribute to a 401(k) or 403(b), income limits do exist if you’re contributing to an IRA. Keep in mind that the income limits are different for traditional and Roth IRAs.
For tax year 2021, if you’re a single filer and your Modified Adjusted Gross Income (MAGI) was under $125,000, you can contribute the full amount to your Roth IRA for 2021 by April 18, 2022. But if your MAGI was higher than $125,000, your contribution limit is slowly lowered until phased out completely. Once your MAGI reaches $140,000 or higher, you are effectively prohibited from contributing anything directly to a Roth IRA.
How you might exceed the contribution limits
Some of the more common reasons for over-contributions include:
- You changed jobs in the middle of the year and contributed to two different 401(k) accounts without realizing you went over the limit.
- You have access to two plans, such as a 401(k) and a 403(b), and you went over the collective limit.
- You received a raise or bonus in the middle of the year, which pushed your total contributions over the limit.
- You are diversifying your retirement savings between a Roth IRA and traditional IRA and exceeded the collective limit.
- If you are self-employed and contributing to a Roth IRA throughout the year, you may have had an unexpectedly strong end of the year, which pushed you above the income limits and made you ineligible to contribute.
How to fix the problem
The good news is that there are steps you can take to limit your penalties and to correct the issue.
1. Request a corrective distribution
To limit your penalties, you’ll need to receive a corrective distribution that equals the over-contribution as well as any earnings or profit you may have realized. This payment must be made to you by Tax Day to avoid any penalties.
If the account in question is an employer-sponsored account — like a Roth or Traditional 401(k) — all you need to do is notify your plan’s administrator and ask them to make the corrective adjustment. Because this process can take some time, especially during the busy tax season, the sooner you notify them, the better off you’ll be. If the account is a traditional (and not a Roth) account, you’ll also need to be issued a new W-2, as the distribution will effectively raise your taxable income for the year.
If the account in question is an IRA, you should simply be able to withdraw the excess contribution as well as any earnings accrued.
2. Apply the excess contributions to the next year
The easiest solution may be to apply the excess contributions to the next tax year. However, it’s important to realize that you will most likely be on the hook for the 6 percent penalty.
3. Recharacterize your Roth IRA contributions
If you find that you’ve over-contributed to your Roth IRA due to exceeding the MAGI limits, and you are still eligible to contribute to a traditional IRA, and you could go through the process of “recharacterizing” your excess contribution to do just that.
To do this, you’ll essentially need to withdraw the over-contributed assets from the Roth account and move them into a traditional IRA. You’ll also need to recharacterize any earnings or losses on those assets. This can get complicated so working with a tax professional can help remove some of the confusion around the process.
Recharacterization needs to occur by your tax deadline to avoid the penalty.
Over-contributions are not a bad problem to have
While it might be a hassle, over-contributing to your retirement accounts is a good sign: It means that you’re taking the idea of saving for retirement seriously. Now you just have to decide how to use those excess funds. Will you pay down debt, save for a down payment on a house or another financial goal, or work a splurge into your budget?
If you’re having difficulty deciding, consulting with a financial advisor can help you understand your options and create a plan that incorporates your goals into a plan that works best for you and your family.
Northwestern Mutual and its financial representatives do not give legal or tax advice. Taxpayers should seek advice regarding their particular circumstances from an independent legal, accounting or tax adviser.