The Risks of Contributing Too Much to a 401(k) or IRA

Over-savers can be hit with tax penalties.

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There are many ways to save for retirement. You can open a Roth IRA with a financial institution, contribute to a 401(k) or Thrift Savings Plan account through your employer, make contributions to a self-employed retirement plan, or use some combination of these accounts. Having several retirement accounts to choose from offers you flexibility when planning your retirement, but it can also open the door for making honest mistakes such as exceeding the annual contribution limits. Once you reach your contribution limits, you must stop making deposits into the account. Here’s a look at the consequences of contributing too much money to your retirement accounts.

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401(k) over-contributions. In most cases, people contributing to a 401(k) account do not have to worry about contributing too much money. The plan administrators typically have a plan in place to prevent such a thing from happening. However, even with protocols, it is still possible to contribute too much in a year, especially if you rolled your account over from a former employer to a new job. The contribution limit for 401(k) accounts generally changes every year based on cost of living increases in the previous year. In 2010, the limit is $16,500 for those under age 50 or an amount set by your employer’s plan.

If you do not catch the mistake – and most people do not until it’s too late – you will end up paying taxes twice on your money. You will be taxed on the money for the year you earned it and also at the time you withdraw the money from your account. You will have to correct the overage before April 15 of the following year. You will need to account for the dollar amount you overpaid and the investment returns that were earned on the account.

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IRA over-contributions. If you contributed too much money to your IRA account, you need to correct the mistake by April 15, the same deadline as with the 401(k). If you correct the mistake by withdrawing the money in a timely manner, you will not be penalized. If you can’t complete the fix in time, you will need to file for a tax extension with the IRS. Money contributed and earnings made on over-contributions are subject to a 6 percent tax penalty for each year the money remains in the IRA account.

IRA contributions for 2010 have not changed since 2008. The maximum amount you can contribute to a regular IRA account is $5,000. If you are going to be 50 or older by the end of the year, you can contribute an additional $1,000.

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How to prevent the penalties. It is essential that you monitor your retirement contributions to ensure you are not going to be subjected to unnecessary taxation. If you are working to prevent depositing too much into retirement accounts, you will not have to worry about trying to untangle the mess before the tax deadline or filing for an IRS extension. If you are concerned about contributing too much, contact your plan administrator for your 401(k) or the financial institution’s account custodian to discuss your concerns.

Ryan Guina is a U.S. military veteran, writer, and professional in the corporate world. He blogs at Cash Money Life and The Military Wallet.