401(k) Contribution Limits, Rules, and Penalties

401(k) Contribution Limits, Rules, and Penalties

by John Anthony Castro, J.D., LL.M.

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Introduction

A 401(k) retirement plan can be an effective way to build wealth while minimizing your tax obligation. Under these plans, any money you contribute is deducted from your taxable income and could save you hundreds of dollars in taxes each year.

Congress put annual limits on the amount of money you can contribute. Otherwise, a person with very high income could put millions of dollars in their 401(k) plan each year, costing the government significant revenue. By placing limits on contributions, Congress can ensure that it is the middle class that benefits most from the tax advantages of 401(k) plans.

The Three Types of 401(k) Contribution Limits

Calculating how much money you are allowed to put into a 401(k) can be a bit tricky. You have to be careful not to exceed the 401(k) contribution limits, and they sometimes change year-to-year. The limits are somewhat more complicated than those of a Traditional IRA or Roth IRA because there are three different types.

The Elective Deferral 401(k) Contribution Limit is $19,000 in 2019. This is the amount the owner of the 401(k) account can contribute from his paycheck.

The Catch-Up 401(k) Contribution Limit is $6,000 in 2019. This amount is the additional money that workers age 50 or older can contribute toward their retirement savings. Thus, a person age 50 or older can contribute up to $25,000 of their pay in one year.

The Defined Contribution Limit is $56,000 in 2019. The defined contribution limit is the total of all elective deferral contributions, catch-up contributions, and any money added to the account by the employer in matching funds or bonuses, and it cannot exceed the lesser of 100% of your compensation or $56,000 in 2019.

So if you're under 50, the most money you can put into a 401(k) in any given year is $56,000 but only $19,000 of that can come from your contributions. The other $37,000 would have to come from your employer, and very few employers offer generous-enough 401(k) packages for you to reach that limit.

Household or Family Contribution Limits

The contribution limits of a 401(k) are determined per employee, not per household or family. Each qualified employee has her own account, and the limits are based on her salary, not the total household income.

Since retirement plans aren't joint accounts, each spouse or family member with a qualified plan can make contributions to his or her own account. If you max out your contributions to your 401(k) in a given year, your spouse can still contribute to his account as well, up to the maximum allowed according to their salary and age.

Limits for High Earners

In some instances, certain high earners in a company might be held to a lower contribution limit or be required to return excess contributions if the retirement plan fails nondiscrimination tests. These tests have specific rules concerning who is highly compensated, who is a key employee, and how much they contribute.

The Actual Deferral Percentage test compares the contributions of highly compensated employees (HCEs) with non-highly compensated employees (NHCEs). A highly compensated employee is someone who makes more than $125,000 or owns more than 5% of the business. Broadly speaking, if the average percentage deferred by the HCE group exceeds that of the NCHE group by more than two percentage points, corrections must be made to close the gap. That might mean that highly compensated employees must reduce their contributions to meet the percentage, or the company may make contributions to the NHCEs.

The second test looks at total plan assets to see what percentage belongs to key employees and what belongs to everyone else. A key employee is an officer making more than $180,000, a 5% owner, or a 1% owner making more than $150,000. A plan must ensure that less than 60% of its assets are held by key employees or it is considered "top-heavy" and must pay contributions to the non-key employees.

Does My Employer’s 401(k) Match Count Toward My Maximum Contribution?

The short and simple answer is no. Employer matching contributions do not count toward your maximum contribution limit as set by the Internal Revenue Service (IRS), which for 2020 is $19,500 of your own money to your 401(k), $26,000 if you’re aged 50 or over ($19,000 and $25,000, respectively, for 2019). These are also the 2020 limits for a number of employee retirement plans that resemble the 401(k), including the 403(b), most 457 plans, and the federal government’s own thrift savings plan.

Nevertheless, the IRS does place a limit on the total contribution to a 401(k) from both the employer and the employee. The limit in 2020 is $57,000, or $63,500 for those aged 50 or older ($56,000 and $62,000, respectively, for 2019).

Avoid the Tax on Excess 401(k) Contributions

Congress is very specific when setting the 401(k) contribution limits that determine the maximum amount of money you can put into your account each year. As of 2019, that maximum is $19,000 each year. If you exceed this limit, you are guilty of making what is known as an "excess contribution". Excess contributions are subject to an additional penalty in the form of an excise tax.

The penalty for excess contributions is 6%. If you remove the excess amount prior to the end of the tax year, you will not be assessed a penalty. In other words, there is good news in that you might have a chance at avoiding this 401(k) penalty if you get the excess contribution out of your account before the tax deadline for the year it was contributed.

Contributed Too Much to Your 401(k)? Here’s What to Do

Contact your employer or plan administrator. Some lingo can be helpful here: Tell your plan administrator you’ve made an “excess deferral.” For example, if in 2019 you contributed $20,000 to your 401(k), you need to be paid back $1,000 in excess deferral. That amount needs to be paid to you before April 15.

The plan administrator is required to return the excess funds to you — as a “corrective distribution” — plus calculate and return additional earnings (if any) and reissue paperwork that corrects the over-contribution. That takes time, and sometimes companies can move slowly doing this.

Get a new W-2 and pay taxes. The returned excess contribution will be added to your total taxable wages for the previous year, so an amended 2019 W-2 will be issued. Your tax bill will rise (or your refund will shrink) relative to the amount of the excess 401(k) contribution.

Handling excess earnings. Any income earned from the excess contribution will count on your tax bill for 2020 (which is due in April 2021). You’ll receive a Form 1099-R at the end of the tax year in which the earnings were paid back to you.

Two Important Notes

Don’t be confused by the jump in contribution limits. The IRS increased 401(k) contribution limits by $500 to $19,500 for the 2020 tax year. But that change is for taxes you’ll file by April 2021. For the 2019 tax year, the $19,000 contribution limit still stands.

This isn’t about your employer’s matching contributions. This scenario addresses only the limit on the pretax wages you contributed to the plan. You should always try to contribute as much as possible to get full matching funds from your employer, but just make sure your contributions don’t exceed the limit.

Dealing with Excess 401(k) Contributions After Tax Day

The bad news. You’ll end up paying taxes twice on the amount over the $19,000 limit if the over-contribution isn’t paid back to you by April 15.

You’ll be taxed first in the year you over-contributed, and again in the year the correction occurs.

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About the Author

John Anthony Castro, J.D., LL.M., is the Managing Partner of Castro & Co., the author of International Taxation in Plain English as well as International Estate Planning in Plain English, an esteemed graduate of Georgetown University Law Center in Washington DC, an OPM Fellow at Harvard Business School, and an internationally recognized tax attorney with offices in New York, Los Angeles, Miami, Chicago, Dallas, and Washington DC.

To provide feedback on this article or suggest an idea for a future article, please contact Tiffany Michelle Hunt, J.D., LL.M., Director of Tax Planning at Castro & Co., at T.Hunt@CastroAndCo.com.


Bluebook Citation: John Anthony Castro, 401(k) Contribution Limits, Rules, and Penalties, Castro Int’l Tax Online Law Journal (February 2, 2020) url.

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