Here's What Happens When You Overcontribute to Your Retirement Account

Retirement accounts like 401(k)s and IRAs offer special tax advantages that help you save compared to keeping this money in a taxable brokerage account. But the government doesn't want to forfeit too much of its tax revenue, so it imposes annual limits on how much you can add to your retirement accounts.

Exceeding these limits is uncommon, but if you do, it can lead to a massive tax headache. Here's what you need to know about excess contributions and how to fix them before the tax deadline.

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What does it mean to overcontribute to your retirement account?

Contribution limits vary depending on your age and the type of account you're using. Here's a look at the limits for 2023:

Source: IRS.

Putting a larger amount into your retirement account this year is considered an excess contribution. To clarify, when calculating your 401(k) contributions for the year, you should only look at what you've personally set aside. Employer-matched funds don't count toward this limit.

And if you have a traditional IRA and a Roth IRA or a traditional 401(k) and Roth IRA, the above contribution limits apply to your total contributions to each type of account. You can't put $6,500 into a traditional IRA and another $6,500 into a Roth IRA, or $22,500 each into a traditional 401(k) and a Roth 401(k).

Lastly, Roth IRAs also have income limits that prohibit high earners from contributing up to the full annual limit to one of these accounts. These earners might have reduced limits, or they may not be able to put money into a Roth IRA directly at all. If you earn six figures, be sure to check these limits before making any Roth IRA contributions to ensure you don't accidentally overcontribute.

What happens if you overcontribute to your retirement account?

Overcontributing to your 401(k) or IRA can lead to tax penalties if it's not corrected before the tax deadline for the year. In the case of your 401(k), you could pay taxes twice on the excess contribution: once in the year you make it and again in the year of the correction.

If you're under 59 1/2 at the time, you could also face a 10% early withdrawal penalty on the excess if you don't make the correction before the tax deadline.

For IRAs, you could face a 6% penalty on your excess contribution every year until you have corrected the excess. Fortunately, there are ways to avoid all these penalties if you take action quickly.

How do you avoid penalties for overcontributing to your retirement accounts?

You can avoid these penalties by removing the excess before the tax deadline for the year. This is April 18, 2024, for the 2023 tax year, or Oct. 15, 2024, if you file for an extension on your tax return.

But it's not as simple as just taking out the extra money you contributed. You also need to remove the earnings on your excess contributions. You don't have to figure that out for yourself, though.

All you need to do is notify your plan administrator of the situation and let it take action for you. Tell it you made an excess deferral and give the amount of the excess you personally contributed. For example, if you're only allowed to contribute $22,500 to your 401(k) and you've deferred $23,000 throughout the year, your excess deferral would be $500.

You might need to fill out a form, but then your plan administrator should take it from there. It will calculate the appropriate amount of earnings to remove, and it will give this and your excess contribution back to you. But this can take time, which is why it's important to begin this process as soon as you notice the overcontribution.

For IRAs, you could also choose to apply your excess contribution to the next year. You'll still have to reach out to your plan administrator about this. If you go this route, your contribution limit for 2024 will be the annual contribution limit -- $7,000 ($8,000 if 50 or older) -- minus the excess contribution you made in 2023.

Those who mistakenly contributed more to a Roth IRA than their income allows might prefer to recharacterize their contributions as traditional IRA contributions instead. This just means you'll take a tax deduction today and pay taxes on these funds in retirement rather than paying taxes today for a tax break later. Again, you'll have to notify your plan administrator if you intend to do this, and you'll need a traditional IRA to move the excess funds into.

Generally speaking, retirement account overcontributions aren't usually something to panic about as long as you act promptly. The longer you wait, the worse it gets. So now is a great time to review your retirement account contributions for 2023 to make sure you have not made excess deferrals.