Why it matters if you contribute too much to a 401(k), IRA, or Roth IRA
Contributing too much to a 401(k), IRA, or Roth IRA can have significant financial consequences. Here are some of the reasons why it matters:
- Taxes: You will need to pay taxes on any excess contributions, plus any earnings they have generated. This can be a significant amount of money, especially if you have a large excess contribution.
- Excise tax: You may also be subject to a 6% excise tax each year that the excess contributions remain in the account.
- Reduced investment earnings: The excess contributions will reduce your overall investment earnings. This is because you will be taxed on the earnings generated by the excess contributions when you withdraw them in retirement.
What to do if you realize at the end of the year or when filing your taxes that you have contributed too much
If you realize that you have contributed too much to a 401(k), IRA, or Roth IRA, you have two options:
- Withdraw the excess contributions. You can do this by contacting your plan administrator or IRA custodian and requesting a corrective distribution. You will need to pay taxes on the excess contributions, plus any earnings they have generated. You may also owe a 10% early withdrawal penalty if you are under age 59½.
- Recharacterize the excess contributions. Recharacterization is a process of moving money from one type of IRA to another. For example, you could recharacterize an excess Roth IRA contribution as a traditional IRA contribution. Recharacterization is only possible if you meet certain requirements, such as making the recharacterization within six months of the end of the year in which you made the excess contribution.
Which option is right for you?
The best option for you will depend on your individual circumstances. If you are able to afford to pay the taxes on the excess contributions, then withdrawing them may be the simplest option. However, if you cannot afford to pay the taxes, or if you want to avoid the early withdrawal penalty, then recharacterization may be a better option.
How to avoid contributing too much in the future
Here are a few tips to help you avoid contributing too much to a 401(k), IRA, or Roth IRA in the future:
- Know the contribution limits. The contribution limits for 401(k) plans and IRAs vary each year, so it is important to check the latest limits before you contribute.
- Track your contributions. Keep track of how much you are contributing to each account each year. This will help you avoid accidentally overcontributing.
- Set up automatic contributions. If you have the option to set up automatic contributions to your 401(k) or IRA, do so. This will help you to consistently contribute the correct amount each year.
If you have any questions about how to correct an excess contribution, or if you are unsure which option is right for you, you should consult with a tax advisor.