If your employer sets up a 401(k) as part of your compensation and benefits package, you can contribute pretax dollars to that 401(k) throughout the year to build up a retirement nest egg. Because the contributions are pretax, you're deferring tax payment on those contributions until you begin receiving distributions at retirement. You're limited as to how much you can contribute every year, however. If you go over the contribution limits, you can get the funds returned to you.
If you contribute more to your 401(k) in one year than you're allowed, you can have the excess deferral paid out of the plan. How that excess is taxed will depend on when you make the withdrawal. If you don't make the withdrawal, you could be taxed twice, and if your plan allows the excess to stay in the account, the plan may end up being disqualified and losing its tax-exempt status.
What Is a 401(k) Plan?
A 401(k) plan, so named because it was created under Section 401(k) of the Internal Revenue Code, is a type of retirement plan that an employer can set up for an employee. The employee can choose a percentage of her gross, pretax wages to be deducted from her paycheck and deposited into an investment account, where it will earn interest. Some employers also offer 401(k) matching, which typically means the employer will "match" up to a certain percentage. For example, your employer may agree to match up to 4 percent, so if you opt to have 10 percent taken from each paycheck, your employer will contribute an additional amount of up to 4 percent. So if your gross pay is $1,000 for the pay period, you will contribute $100, and your employer will contribute $40.
How Are Pretax Contributions Beneficial?
The biggest benefit of a 401(k) is the ability to make pretax contributions (the IRS calls these "elective deferrals"). Because the money comes out of your check before the taxes, you're setting aside money tax-free, and that tax-free money will grow over time without being considered part of your taxable income. You aren't taxed on any of the funds invested in the 401(k) until you start receiving distributions after you retire, at which point the distributions are taxed like regular income. The interest you earn on your contributions is also not taxable income until distributed.
How Much Can You Contribute to a 401(k)?
The IRS has set contribution limits for 401(k) plans. An individual can only contribute a certain amount every year from her pretax earnings to the 401(k). The limits do not include employer contributions but only the funds that are actually deducted from your paycheck.
401(k) Contribution Limits in 2017, 2018 and 2019
The 401(k) max in 2017 was $18,000. That is, during the 2017 tax year, you could not contribute more than $18,000 from your pretax income to your 401(k) plan investment account. In 2018, the limit is $18,500, and the IRS has announced that the limit will be increased to $19,000 for the 2019 tax year.
If your 401(k) is a SIMPLE 401(k), these contribution limits are lower ($12,500 for 2018 and $13,000 for 2019).
In certain circumstances, workers age 50 and over may be eligible to make "catch-up" contributions in excess of the contribution limit. The catch-up contribution amount has remained $6,000 since 2015 and will remain so through 2019. That amount is $3,000 for a SIMPLE 401(k).
Other Limitations on Your 401(k)
Your 401(k) cannot grow to infinity every year, unfortunately. You're further limited on how much can be contributed from any source to your 401(k). This means that adding all your contributions and your employer's contributions cannot exceed a certain amount; that is, not only are your contributions capped, but the total that can be deposited into the investment account from any source is also capped.
2018 Caps on Total 401(k) Additions
In 2018, the total funds added to your 401(k) investment account could not exceed either 100 percent of your annual compensation or $55,000 ($61,000 including catch-up contributions), whichever is lower. For example, if you made $110,000 in 2018, the total amounts added to your account are capped at $55,000; if you made only $45,000 and were under age 50, your account contributions from any source could not exceed $45,000.
2019 Caps on Total 401(k) Additions
In 2019, the cap is either 100 percent of your total compensation or $56,000 ($62,000 with catch up contributions), whichever is lower. Not many people are able to hit these caps, as most employers limit their matching.
What Happens if You Make an Excess Contribution?
To back out of an excessive elective deferral, you can simply seek a 401(k) excess contribution refund. If you realize your contributions for the tax year have exceeded the limit, you must notify your plan right away and request a refund of the excess deferral. The plan will then pay you that amount to maintain the correct contribution cap. You must ask for your refund by April 15 of the following year, however, to avoid double taxation.
Withdrawing Your Excess Contribution by April 15
If you make excess contributions in 2018 and make the withdrawal of the excess before April 15, 2019, you don't have to report the withdrawal as income for 2019. You only need to report it for 2018 (although if you earned income on that withdrawal after depositing it into your bank account in 2019, for example, you do report that income as gross income for 2019).
So if you make an excess contribution of $5,000 in 2018 but you report it and request a withdrawal of that amount before April 15, 2019, you will be taxed on that income on your 2018 return because you earned it in 2018, but you'll not be taxed on the withdrawal for the 2019 tax year. If you then deposit the $5,000 withdrawal into a bank account and make $50 in interest on it in 2019, you'll be taxed on the $50 interest earned in 2019.
Withdrawing Your Excess Contribution After April 15
If you don't make the withdrawal before April 15 of the year in which your return is due, the excess is essentially double-taxed. You'll be taxed on the excess amount you contributed for the tax year of contribution, and then you'll be taxed again on the withdrawal during the tax year in which you received the withdrawal. For example, if your excess contribution in 2017 was $5,000 and you didn't ask for the withdrawal until June 2018, you'll be taxed on the $5,000 for the 2017 tax year and then again for the 2018 tax year, which is when you withdrew it.
Failing to Withdraw Your Excess Contribution
If you fail to withdraw your excess contribution at all, your plan could become disqualified as a 401(k) plan, and all the benefits of a 401(k) will no longer be available. The plan will lose its tax-exempt status and essentially becomes a trust. Any contributions your employer makes to the new trust will be taxable income to you. You also won't be able to roll over any of the funds in the plan to another plan to make them tax exempt.
- IRS: Retirement Topics - 401(k) and Profit-Sharing Plan Contribution Limits
- IRS: Retirement Topics - What Happens When an Employee has Elective Deferrals in Excess of the Limits?
- IRS: 401(k) Plan Overview
- IRS: IRS Announces 2017 Pension Plan Limitations; 401(k) Contribution Limit Remains Unchanged at $18,000 for 2017
- IRS: Publication 560 (2017), Retirement Plans for Small Business
- IRS: Tax Consequences of Plan Disqualification