Is storing huge sums of money in a tax-deferred retirement account ever a bad idea? It is when you surpass the annual IRS limits. Whether deliberate or not, the penalties can be detrimental. Here's how overfunding happens and what steps you can take to solve the problem.
How Overfunding Happens
Overfunding retirement accounts occurs more than you might think. It can be the result of a job change that causes you to take part in two different employer retirement plans. Occasionally people forget they made IRA contributions earlier in the year and do it again later. Others forget that the IRA limit is the total of all accounts, not per account. The rules are complex. Traditional IRAs can't be added to after age 70½, while Roth IRA contributions are subject to income limits. In addition, all contributions are predicated on having earned income.
The yearly Roth and Traditional IRA contribution limit is $5,500 ($6,500 if age 50 or older). If you exceed this amount, you pay a 6 percent penalty on the overpayment every year until it's corrected, plus a potential 10 percent penalty on the investment proceeds attributed to the overfunded amount.
The fix: If the overfunding is found before the filing deadline (plus extensions), you can withdraw the excess and any income earned on the contribution to avoid the 6 percent penalty. You will possibly owe a 10 percent penalty in addition to ordinary income tax on the earnings of the excess contributions if you're under age 59½. Frequently you can apply the contribution to the upcoming year. If your problem is due to age (70½ or older for a Traditional IRA) or income limit (for a Roth IRA), consider recharacterizing your contribution from one IRA type to another.
The rules for correcting an overfunded 401(k) are a slightly more rigid. You have until April 15 to return the funds, period. The nature of the penalty is also different. The excess amount is taxable in the year of the overfunding, and taxable again when withdrawn. So, you could pay the penalty several times on the same amount. And, in certain cases, overfunding a 401(k) could cause it to lose its qualified status.
The fix: If you suspect an overpayment situation, contact your employer right away. Adjust your contribution amount before the end of the year and try to get the problem resolved that way.