Employer-sponsored retirement plans, like a 401(k), allow you to save money on a pretax basis. The money isn't included in your income in the year you earn it: it grows tax-free and then is finally taxed when you take distributions. However, the Internal Revenue Service limits how much you can put into your 401(k) each year and penalizes you if you contribute too much.
Excess Counts as Income
If you have excess pretax contributions to your 401(k) plan, you must include the amount of the excess in your taxable income for the year. For example, if you contribute $3,000 more than you're allowed to, you must add $3,000 to your taxable income for the year even though the money was put in a tax-deferred account.
Distributions Still Taxed
Even though you pay tax on the excess contributions, they don't create a basis in your 401(k) plan. This means that when you eventually take distributions from the 401(k) plan, those excess contributions are taxed just like the pretax contributions you made. Effectively, you're paying income taxes on the same dollars twice.
The elective contribution limit applies to all your 401(k) plans, including plans at different employers and both traditional and Roth 401(k)s. As of 2012, the maximum contribution you can make is $17,000 if you're under 50. If you're 50 or older, you can contribute up to $22,500. In addition, the total amount that you and your employer contribute to your 401(k) plan can't exceed $50,000 if you're under age 50 or $55,500 if you're 50 or older.
Correcting Excess Contributions
To avoid the double taxation, you must withdraw the excess contributions before April 15 of the following year. In addition to the excess contributions, any earnings on those contributions must also be withdrawn and included in your income. However, you do not have to pay the early withdrawal penalty. For example, say you contributed $3,000 too much, but by the time you realized it, the $3,000 had grown to $3,200. To correct the excess contribution, you would have to take out $3,200 before April 15 of the following year.
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