A 401k is a tax-advantaged retirement plan that allows participants to contribute with pre-tax dollars and build savings faster through tax-deferred investment growth. Qualified distributions from the plan, usually after the participant has reached age 59 1/2, are taxed as regular income. Because of these tax advantages, 401k participants who exceed maximum contribution limits will pay certain consequences.
There are different kinds of 401k plans with different limits. The maximum annual contribution to a traditional or safe harbor 401k as of 2011 is $16,500. If the person is 50 or over she can contribute an additional amount, referred to as a catch-up contribution, of $5,500 per year. A SIMPLE 401k allows a maximum contribution of $11,500 in 2011, with a maximum catch-up contribution of $2,500. Any 401k plan may be subject to lower limits due nondiscrimination laws, where highly-compensated employees – HCEs -- have their deferrals to the plan limited by the average amount the nonhighly compensated employees contribute.
Normally a person’s employer keeps track of all 401k contributions and will stop making deductions once the account has reached its limit. However, the IRS limits are combined limits for all 401k plans the employee participates in. If a person changes employers during the year or works for more than one employer, it is possible to contribute more than the allowable amount, since each employer tracks contributions only to its own plan. In some cases, a highly compensated employee will exceed the limit due to the fact that the average deferral percentage – ADP – for the HCEs exceeds the allowable amount.
Excess money in a 401k plan is subject to tax for the year in which the overage occurred. This means that the money is taxed twice. When the account goes over the limit the excess in the account is taxed as income for that year even though it remains in the 401k account. It is taxed again at the time it is distributed, normally after retirement. If the overage is left in the account it may also cause the 401k to no longer be qualified under IRS rules, which has consequences for all participants as well as the employer.
If a person has exceeded her 401k limits for the year, she can correct the situation up to her income tax filing due date, usually April 15 of the following year. The excess contributions must be removed as well as any additional income earned by that portion of the money. If the problem is with a group of contributors, such as the highly compensated employees, the employer will normally refund the over-limit amount to each employee. Removing the excess from the account serves to let the account retain its qualified 401k status. It also prevents the account owner from having to pay taxes twice on the same amount. The money will be taxed as income for the year in which it was distributed but no further taxes will be due on it.
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