Friday, September 05, 2008

Over Contributing to Your 401(k)

A company 401(k) is the basis for many people's retirement planning strategy, and for this reason investing your 401(k) assets wisely is something you should take the time to plan and execute. However, today's post is not about investing your 401(k) money more efficiently, it's about making sure that you don't over contribute to your plan. In 2008, the contribution limit is $15,500 per individual, and if you are over 50 you are entitled to make catch-up contributions of an additional $5,000. Contribute more than this limit and you find yourself in a little bit of a bureaucratic nightmare.

First up, how can one even over contribute? Plan administrators typically ensure that employees cannot over contribute, by stopping all excessive contributions. However, they can only do this if they are aware that you are over contributing. If, for example, you switched jobs mid-year, there is no way for administrators to know the amount that you already contributed to your 401(k) before you joined your new employer. In fact, my wife and I each ran into an over contribution situation in exactly this way.

So, how do you avoid this over contribution situation?

(i) Calculate Your Limit - if you contributed to more than one plan during the year, deduct your earlier contributions from the maximum allowed contribution to determine how much you can still contribute. Once you have this number, divide it by the number of pay-checks remaining in the year and make sure that your contributions do not exceed this number.

(ii) Mind Income Changes - if your contributions are set as a percentage of your income, and you receive a raise before the end of the year, be sure to adjust your contributions to account for this increase to avoid over-contribution.

(iii) Pay Attention to Bonuses - if you are lucky enough to receive an unscheduled bonus, be sure to check if 401(k) contributions have been deducted from your bonus, and adjust your contributions accordingly.

What to do if you over contribute? Contact your payroll representative as soon you discover the error. Your 401(k) plan will issue you a refund check, which will be taxed at your normal income level. In some cases, if you discover the error after the end of the tax year for which contributions were made, you may also receive income that will be attributable to the following tax year. It's a hassle best avoided. Trust me. Last year, after switching jobs in the middle of the year, my wife unintentionally over-contributed to her 401(k). We only discovered the error in February when doing our taxes, the error took until early April to correct, and the changes will also impact our 2008 tax return. As I said, best avoid this hassle if you can.

By the way, if you are interested in improving your company's 401(k) plan, you may also be interested in this previous post.

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