A 401K plan helps employees automatically fund their retirement with pre-tax dollars. To curb the abuse of these tax advantages, the IRS imposes limits and enforces penalties for over contributing. Many wonder whether their 401K will automatically stop at the limit and what to do if it doesn’t.
Most 401K plans will automatically stop further contributions once the year’s limit has been reached. However, because the IRS does not mandate that employers do so, you should check with your Human Resources Department for clarification.
This article will discuss, in detail, what happens when you reach the limit for 401K contributions, what to do once you’ve noticed that you’ve overcontributed to your 401K, and how to prevent it altogether.
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Table of Contents
What Happens When You Reach 401K Limit?
Each year the IRS reevaluates the 401K contribution limit based on inflation. As of 2021, the maximum individual contribution is $19,500.
The maximum employer contribution is $38,500, which comes to a total of $58,000 in savings each year. If you are 50 or older, the individual contribution jumps to $26,000 per year.
Depending on your income and what percentage you allocate to your 401K from each paycheck, you can quickly max out your contribution. Here’s what could happen to your contributions.
Individual Contributions
It’s not guaranteed that your contributions will automatically stop at the limit. So, once you’ve realized that you are at risk of reaching the limit, you should reach out to your HR department immediately. By doing so, they’ll be able to advise you if the contributions will stop on their own or if they need to be manually stopped.
Employer Contributions
Once you’ve reached your max limit of individual contributions, it’s possible that your employer could stop contributing. This is because some employers match on a per-paycheck basis.
You’ll miss out on the total annual match if this happens, meaning you’ll be losing free money. However, some employers offer “true-up” payments which is when you get the maximum amount of matching contributions allowed under the plan even if you max out early. Talk to your HR team to be sure what your plan offers.
What To Do When You Overcontribute to 401K?
The IRS limits the amount contributed to a 401K to level the playing field for tax advantages. Since 401K plans are funded with pre-tax dollars, the more someone earns, the more they can afford to put away. Therefore, the IRS also enforces tax penalties for over contributing.
If you notice that you’ve overcontributed to your 401K, you should:
- Notify your employer immediately. You are required to notify your employer of any excess contributions (deferrals). Once recognized, they should refund this amount to you before April 15th of the following year.
- Pay taxes. The amount refunded to you should be added to your taxable income. This will increase the amount of taxes you owe or decrease the amount of the refund you get.
However, if the excess amount is not refunded back to you before April 15th, then you will have to pay taxes on the amount twice (the current year and the next). Additionally, you will be subject to an excise tax of 6%.
Also, to make sure that you’re not sitting on your hands and losing tax advantages, you should look into funding other retirement vehicles like an Individual Retirement Account (IRA).
How To Prevent Over Contributing to 401K?
It’s more important than ever to make sure that your future self is taken care of. However, you should do so in a way that does not put you at risk in the present. Luckily, there are a few things that you can do to make the most out of your 401K benefits while protecting yourself.
Calculate Your Contribution
The most effective way of preventing overcontribution is by calculating the correct percentage to contribute from each paycheck. To do this, you should:
- Divide the annual limit by the number of yearly paychecks you receive. If you’re paid weekly, divide by 52, biweekly is 26, and monthly is 12
- Divide the resulting number by the gross amount of your paycheck.
- Multiply the remaining number by 100 to get the percentage to allocate to you 401K.
Let’s see an example of this.
Annual Individual Contribution: $19,500
Annual Salary: $100,000
Pay Schedule: Biweekly (26 payments per year)
$19,500 ÷ 26 = $750
$750 ÷ (100,000 ÷ 26) =
$750 ÷ $3846.15 = 0.195
0.195 X 100 = 19.5%
Essentially this means that to max out your contributions for the year, you need to save $750 pre-tax dollars each paycheck. For a salary of $100,000, this is 19.5%. You can check your math by multiplying the decimal by the annual salary. This should give you a number close to the annual limit.
Keep Track of Your Contributions
With investment accounts, it’s easy to “set it and forget it.” This can be a good tactic for minimizing the temptation to withdraw, but it’s better to be an active part of your financial future. You don’t have to go overboard by tracking each penny, but you should at least review your monthly or quarterly statements.
This is especially important if you have multiple jobs, have switched jobs, or have received a raise. You may think that having multiple contributions will boost the amount you can save, but the limit applies to your 401K plans as a collective.
This means that no matter how many accounts you have, the total amount can not exceed $19,500. Therefore, you must keep track. If you’ve gotten a raise, you’ll need to manipulate your contribution percentage to make sure you stay within the limit.
This will keep you on track with your contributions and your retirement goals. Your statement should outline the number of contributions both you and your employer have made within a given period.
It’ll also show account activity related to the assets it is invested in and your rate of return. When it comes to solidifying your future, do not turn a blind eye.
Get the Most of Your Employer Match
Overcontributing affects more than your taxes; it can potentially hinder the amount of free money you get from your employer. When it comes to the employer match, you should aim to get as many benefits as possible.
The amount that they will match will depend on the employer. However, 71% of employers match half of what you contribute up to 6% of your pay. At the same time, 21% match what you contribute dollar for dollar, but only up to 3%.
The first step to getting the most benefits is to clarify what type of incentives they are offering. For instance, if they match up to 6% of your pay, your contributions should be no less than 6%. By doing so, your 401K will grow faster, and you won’t be leaving money on the table.
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Conclusion
While getting the most out of your 401K plan is important, maxing out early or overcontributing can have negative consequences. Though most employers will automatically stop your 401K individual contributions once the year’s limit has been reached, this isn’t a guarantee. Check with your HR department to be sure.
If you’ve already overcontributed to your 401K, notify your employer immediately to stop further contributions, and the excess can be withdrawn. However, the best way to manage this is by preventing it. You can do this by calculating the correct percentage to contribute and regularly tracking your progress.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
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