Monthly Archives: June 2019

Understanding Your 401(k)

As an employee, your employer’s 401(k) plan can be your most important wealth building tool. Understanding how it functions will help you build your wealth in a tax efficient manner.

The Plan

A 401(k) plan is established by an employer. The employer provides the account, the account administration, and the investment choices. Usually, the investment options include a menu of stock and bond mutual funds and/or similar investments. In some plans, employer stock is one of the investment choices.

While the employer administers the plan, most of the assets in the plan (see Vesting below) belong the employees in individual accounts. Therefore, the employees, not the employer, enjoy the benefits and burdens of the economic appreciation and/or depreciation of the investments.

Creditor Protection

401(k) plans are subject to a host of rules, most of which (from a practical perspective) are the concern of the employer, not the employee. One important benefit of the rules for employees is that under ERISA, assets in a 401(k) plan are generally protected from creditors. During your lifetime only two creditors can access assets in your 401(k): the IRS and an ex-spouse.

Vesting

Contributions to a 401(k) made by the employee (referred to as “employee deferrals” and “after-tax contributions” — see numbers 1 and 3 below) are always immediately “100% vested.” This means that regardless of whether the employee leaves the employment of the employer tomorrow, he or she owns the money he or she contributed to the 401(k) and any related growth.

However, contributions to a 401(k) account made by the employer may be subject to a vesting schedule. Simply put, vesting means amounts become the property of the employee after the employee has been employed by the employer for a certain period of time.

Some plans use a gradual vesting schedule. The least generous of these is as follows:

Years of ServiceVesting Percentage
220%
340%
460%
580%
6100%

More generous (i.e., quicker) vesting is permissible.

Some plans use a “cliff” vesting schedule. This means that employer contributions go from 0% vested to 100% vested when the employee has been employed for a certain period. The longest permissible period is 3 years.

The growth associated with employer contributions is also subject to vesting.

Vesting incentivizes staying with the same employer for a sufficient period of time to capture all of the employer contributions to a 401(k) plan. It can also incentivize returning to a former employer if you have worked a number of vested years of service for them.

Some plans provide for 100% immediate vesting for employer contributions as well as employee contributions.

Contributions

There are five types of contributions to 401(k) plans, listed below in order of their prevalence (employee deferrals being the most prevalent).

1. Employee Deferrals

Employees can contribute, through payroll withholding, a portion of their salary to a 401(k) plan. All 401(k) plans offer “traditional” contributions, meaning employees can contribute amounts to the 401(k) plan and exclude those amounts from their taxable income for the year. Some plans, but certainly not all plans, also offer “Roth” contributions, which are not excludible from taxable income, but, if properly withdrawn, can be tax free in the future when withdrawn.

Employee deferrals are the only type of contribution to a 401(k) plan that can be done as a “Roth” contribution. All other contributions are “traditional” contributions.

Read here for more on the desirability of Roth contributions compared to traditional contributions.

Neither traditional nor Roth contributions reduce the amount of income subject to payroll (i.e., Social Security and Medicare) taxes.

2. Matching Contributions

Matching contributions are one of the most powerful ways employees can build wealth. Previously, I have written that if you participate in a 401(k) plan with an employer match, you must make it your top wealth building priority to contribute at least enough to your 401(k) to secure all of the employer match.

How does it work? Different employers have varying matching programs. There are two components: 1) the percentage of salary that is matched, and 2) the percentage of the match.

Here is an illustrative example:

Example 1: Elaine Benes works for Pendant Publishing. She is under 50 years old and earns $100,000 in annual W-2 wages. Pendant Publishing matches 100 percent of employee contributions up to 3 percent of salary, and matches 50 percent of employee contributions for the next 2 percent of salary. Based on this matching program, Elaine would be a fool not contribute at least 5 percent of her salary to Pendant Publishing’s 401(k) plan. Doing so will earn her $4,000 of matching contributions from Pendant Publishing on her $5,000 of employee contributions.

Employers vary in terms of when they match contributions. Some employers match employee contributions only once a year (usually at or after year-end). Other employers match employee contributions each pay period. If you work for an employer that does so, you need to be careful not to max-out your 401(k) early in the year, as each pay period requires an employee 401(k) contribution in order to obtain the match. Here is an example:

Example 2: The facts are the same as Example 1. In addition, Pendant Publishing’s matches 401(k) contributions every pay period, and has 24 pay periods per year. Elaine believes it is a good idea to accelerate her 401(k) contributions, and thus contributes $3,750.00 of her salary for each of the first 6 pay periods of the year ($22,500 total) and makes no contributions the rest of the year. For those 6 pay periods she receives an employee match of $166.67 each pay period ($100,000 divided by 24 times 4 percent) for a total annual match of $1,000. By doing this, Elaine misses out on $3,000 of her potential employer 401(k) match, because for the next 18 pay periods, she contributes nothing to her 401(k).

Some 401(k) plans adjust for this and would fully match Elaine’s contribution (in her case, by adding $3,000 to her 401(k) plan), but many do not. In Elaine’s case, she should have stretched out her contribution such that she contributed at least 5 percent of each pay period’s paycheck to her 401(k).

Note that employers are not required to provide a matching program. There are some employer 401(k) plans that provide no match at all.

Tax Treatment: Employer match contributions are traditional contributions. They are not subject to income tax when added to your 401(k), but they will be in the future when withdrawn (as will the growth on matching contributions). Matching contributions are not subject to payroll taxes.

3. After-Tax Contributions

Some 401(k) plans allow for employees to make so-called after-tax contributions to their 401(k) through payroll withholding. These contributions are not excluded from the employee’s taxable income, but do create basis in the 401(k) account. After-tax contributions are what make Mega Backdoor Roth IRA planning possible. Unless one is engaging in Mega Backdoor Roth IRA planning, in most cases after-tax contributions are not advisable.

Tax Treatment: After-tax contributions do not reduce the employee’s taxable income (for both income tax and payroll tax purposes). In the future after-tax contributions are taxable to the employee as withdrawn, but the employee can use the created basis to reduce the income inclusion. Depending on how the 401(k) account is disbursed, that basis recovery may be subject to the Pro-Rata Rule.

4. Profit-Sharing Contributions

Some 401(k) programs have a profit-sharing program, whereby the employer contributes additional amounts to each employee’s 401(k) account based on a formula.

Tax Treatment: Profit-sharing contributions are traditional contributions and are treated in the same manner as matching contributions, including being exempt from payroll tax.

5. Forfeitures

Because of vesting, employees forfeit unvested amounts in their 401(k)s when they leave the employer’s employment prior to fully vesting in the 401(k). When that happens, the unvested amounts must be accounted for. In some plans, the unvested amounts are used to offset plan administrative costs. In other plans, forfeited amounts are added to the remaining participants’ accounts.

Tax Treatment: Forfeitures are traditional contributions and are treated in the same manner as matching contributions, including being exempt from payroll tax.

Contribution Limits

Contribution limits get a bit complicated because there are two distinct 401(k) plan contribution limits, not one. Numerical limits are updated annually by the IRS to account for inflation. The numbers provided below are the numbers for 2023.

Employee Deferrals

There is an annual employee deferral limitation. For 2023, that limit is the lesser of $22,500 or total compensation (if under age 50) and the lesser of $30,000 or total compensation (if 50 or older). The limit applies to Roth employee contributions, traditional employee contributions, or any combination thereof.

This limit is per person, not per employer. Thus, those with side hustlers must coordinate employee deferrals to their large employer 401(k) plan with employee deferrals to their Solo 401(k). I discuss this topic in detail in my book, Solo 401(k): The Solopreneur’s Retirement Account.

All Additions

There is a second, less understood limitation on 401(k) contribution. The annual limit for all additions to 401(k) and other employer retirement accounts is the lesser of $66,000 or total compensation (if under age 50) and the lesser of $73,500 or total compensation (if 50 or older).

The all additions limit applies to the sum of numbers 1 through 5 above (employee deferrals through forfeitures) plus a sixth amount. The sixth amount is the amount which is contributed by your employer to another qualified retirement plan account on your behalf.

Some employers offer additional qualified retirement plans. These plans often provide for a contribution to an account by the employer based on a stated percentage of compensation. Employers use various names for these plans. Contributions may be subject to vesting and are traditional contributions that are not subject to payroll tax.

The all additions limit applies per employer, not per employee as the employee deferrals limit does.

Watch me discuss the all additions limit on YouTube.

Auto Enrollment

Many employers now auto-enroll new employees in a 401(k) plan. This has two components: contribution level and investment choice. In most cases, new employees should not simply settle for auto-enrollment. When you start a job, you should review your new 401(k) plan and make informed decisions regarding contribution level and investment choice.

Contribution Level

Auto-enrollment will set a contribution level. Not all employers set the contribution level at a level that maximizes employer matching. Even if the automatic contribution level is set at a level that maximizes the employer match, that level might not be the appropriate level for any particular person.

Investment Selection

Plans typically have a default investment plan for new 401(k) participants. It is best to review your investment options when you start a new job and select an appropriate investment allocation for your circumstances.

Withdrawals from Traditional 401(k)s

When a taxpayer is 59 ½ years old or older, they can withdraw amounts in a traditional 401(k) penalty free. Withdrawals are included in taxable income as ordinary income. Beginning at age 72, taxpayers must take out a required minimum distribution (“RMD”) for each year. The RMD is computed based on IRS tables.

If a taxpayer withdraws money from a 401(k) prior to age 59 ½, the withdrawal is not only taxable, it is subject to a 10 percent early withdrawal penalty, unless a penalty exception applies.

Taxpayers may transfer amounts in a 401(k) to another 401(k) to an IRA. Amounts in traditional 401(k)s and IRAs can be converted to Roth accounts. Such conversions create taxable income, but are not subject to the early withdrawal penalty.

Conclusion

Your workplace 401(k) plan is a vitally important wealth building tool. It is important to be an informed user of your 401(k) in order to build tax advantaged wealth.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here. 

Excess Contributions to an IRA

There are limits to how much can be contributed to traditional IRAs and Roth IRAs. This post describes how excess contributions happen and how to resolve them.

Three introductory notes. First, if you find that you have made an excess contribution, you may be well advised to seek professional advice. Second, please don’t panic, but make sure to act swiftly. Excess contributions are resolvable but do not benefit from delays. Third, you should not plan to make an excess contribution for a variety of reasons.

Traditional IRAs

There are (generally speaking) three situations that generate an excess contribution to a traditional IRA. They are:

  • Contributions are made for a year the taxpayer (and their spouse) does not have earned income.
  • Contributions are made in excess of the annual contribution limits.
  • Rolling into an IRA an amount that did not qualify to be rolled in.

This last category is not immediately obvious, but it does occasionally occur. For example, a taxpayer might inherit a taxable account and incorrectly roll it into an inherited IRA. Or a taxpayer might incorrectly roll an IRA they inherited into their own IRA. Or a taxpayer might attempt a 60-day rollover of amounts previously in an IRA and roll the money into an IRA after the 60-day deadline. Note that in some cases, this last mistake can be resolved by obtaining a private letter ruling from the IRS (doing so is beyond the scope of this post).

For 2019 and prior taxable years, there is an additional category: contributions to a traditional IRA when the taxpayer was 70 1/2 or older. The SECURE Act eliminates the prohibition on those 70 1/2 and older contributing to a traditional IRA.

Resolutions

Recharacterization

Prior to the 2020 tax year, if you qualified to make a contribution to a Roth IRA, but not to a traditional IRA, you could direct your financial institution to recharacterize the contribution to a Roth IRA. This scenario only applied in situations where the taxpayer was over age 70 ½ when the contribution was made to the traditional IRA.

Now there is no scenario where this would be relevant. Anyone not qualifying to make a contribution to a traditional IRA would also not qualify to make a contribution to a Roth IRA.

However, recharacterizations of contributions from traditional IRAs to Roth IRAs can make sense for some taxpayers for tax planning reasons, and are allowable if done properly.

To recharacterize, you must contact the financial institution and direct them to move the contribution and its earnings to a Roth IRA. This must be disclosed in a white paper statement attached to your federal income tax return. The recharacterization deadline is the extended due date of the tax return (generally October 15th).

Withdrawal

A second way to correct an excess contribution to a traditional IRA is to take a “corrective distribution” of the excess contribution and its earnings from the IRA. You will need to inform your financial institution of the excess contribution and request a corrective distribution of the excess contribution and the earnings attributable to the excess contribution. If the excess contribution is withdrawn prior to the extended filing deadline, the withdrawal of the contribution itself is generally not included in taxable income.

As observed in IRS Publication 590-A, page 34, in most cases the financial institution will compute the earnings attributable to the excess contribution. The earnings will be included in taxable income for the actual year the excess contribution was made. For example, if a 2023 IRA contribution is made in January 2024, and the taxpayer later takes a corrective distribution of that contribution and its earnings, the earnings will be includible in taxable income in 2024. In those cases where the taxpayer must compute the earnings, IRS Publication 590-A Worksheet 1-3 is a resource for figuring the earnings or loss.

See Example 1 in this article for insights on the reporting timing of earnings attributable to corrective distributions.

Up until the passage of SECURE 2.0, the earnings were also subject to the ten percent early withdrawal penalty (unless an exception otherwise applied). However, SECURE 2.0 Section 333 repealed the early withdrawal penalty with respect to withdrawals of earnings occurring pursuant to a corrective distribution. Note further that as of March 1, 2024 there is now some doubt as to the on going validity of SECURE 2.0.

If the corrective distribution occurs after the taxpayer files their tax return for the relevant taxable year, but before the extended filing deadline for the year (generally October 15th), the taxpayer must file an amended return which reports the corrective distribution.

A quick note on corrective distributions (as applied to both traditional IRAs and Roth IRAs): they can be done if the taxpayer has changed their mind. Natalie Choate makes this point in her excellent treatise Life and Death Planning for Retirement Benefits (8th ed. 2019, see page 132). Corrective distributions are not limited to simply those times when the taxpayer has made a contribution in excess of the allowed limits.

Apply the Contribution to a Later Year

You can keep an excess contribution in a traditional IRA and apply it to a later year, if you are eligible to make a traditional IRA contribution in that later year. This method does not avoid the six percent penalty discussed below for the year of the contribution, but it allows the taxpayer to avoid taking a distribution of the excess contribution and stops additional impositions of the six percent excess contribution penalty. Generally, this method is only effective if the amount of the excess contribution is relatively modest, since a large excess contribution cannot be soaked up by only one year’s annual IRA contribution limit.

Penalties

If you do not resolve the excess contribution prior to the extended deadline for filing your tax return, you must pay a six percent excise tax on the excess contribution annually until the excess contribution is withdrawn from the traditional IRA. You report and pay the excise tax by filing a Form 5329 with the IRS. Because this six percent tax is imposed each year the excess contribution stays in the traditional IRA, it is important to correct excess contributions to traditional IRAs promptly.

Note further that excess contributions withdrawn after the extended filing deadline are generally included in taxable income, though the taxpayer can recover a portion of any IRA basis they have under the Pro-Rata Rule.

Roth IRAs

There are (generally speaking) four situations that cause an excess contribution to a Roth IRA. They are:

  • Contributions are made for a year the taxpayer (and their spouse) does not have earned income.
  • Contributions are made in excess of the annual contribution limits.
  • Contributions are made for a year the taxpayer exceeds the modified adjusted gross income (“MAGI”) limitations to make a Roth IRA contribution)
  • Rolling into a Roth IRA an amount that did not qualify to be rolled in.

A rather common excess contribution occurs when taxpayers contribute to a Roth IRA in a year they earn in excess of the MAGI limits. That can happen for a host of reasons, including end of year bonuses or other unanticipated income.

Another somewhat common mistake in this regard is made by those subject to required minimum distributions (“RMDs”) when trying to convert traditional IRAs to Roth IRAs. In early January a taxpayer might convert a chunk of their traditional IRA to a Roth IRA. This creates a problem if the taxpayer did not previously take out their annual RMD for the year. There is a rule providing that RMDs are the first money to come out of an IRA during the year, and RMDs may not be converted to Roth IRAs. Thus, “converting” the first dollars out of a traditional IRA (an RMD) during the year creates an excess contribution to a Roth IRA.

Resolutions

Recharacterization

Assuming that the taxpayer qualifies to make a contribution to a traditional IRA, the excess contribution to a Roth IRA can be recharacterized as a contribution to a traditional IRA. Generally, the taxpayer must contact the financial institution and direct them to recharacterize the contribution and its earnings into a traditional IRA and must file a white paper statement with their tax return explaining the recharacterization.

When the taxpayer’s income puts him or her over the Roth IRA MAGI limits, recharacterization is often how excess contributions to Roth IRAs are resolved. In such cases, they will generally qualify to make a contribution to a traditional IRA, so a recharacterization is often the go-to method of correcting an excess contribution to a Roth IRA.

Note that the recharacterization deadline is the extended due date of the tax return (usually October 15th).

Withdrawal

A second way to correct an excess contribution to a Roth IRA is to take a corrective distribution of the excess contribution. You will need to inform your financial institution of the excess contribution and request a corrective distribution of the excess contribution and the earnings attributable to the excess contribution. The withdrawal of the excess contribution itself is generally not taxable.

The financial institution will compute the earnings attributable to the excess contribution. The earnings will be included in taxable income for the actual year the excess contribution was made. The same inclusion timing rules applicable to traditional IRA corrective distributions (discussed above) apply to the earnings from a Roth IRA corrective distribution.

If the corrective distribution occurs after the taxpayer files their tax return for the relevant taxable year, but before the extended filing deadline for the year (generally October 15th), the taxpayer must file an amended return which reports the corrective distribution and includes the earnings in taxable income (if the original contribution actually occurred in the year covered by the tax return).

Apply the Contribution to a Later Year

As with excess contributions to traditional IRAs, you can keep an excess contribution in a Roth IRA and apply it to a later year, if you are eligible to make a Roth IRA contribution in that later year. This method does not avoid the six percent penalty discussed below for the year of the contribution, but it allows the taxpayer to avoid taking a distribution of the excess contribution and stops additional impositions of the six percent excess contribution penalty. Generally, this method is only effective if the amount of the excess contribution is relatively modest, since a large excess contribution cannot be soaked up by only one year’s annual Roth IRA contribution limit.

Penalties

As with excess contributions to traditional IRAs, if you do not resolve the excess contribution to your Roth IRA prior to the extended deadline for filing your tax return, you must pay a six percent excise tax on the excess contribution annually until the excess contribution is withdrawn. It is best to resolve an excess contribution to a Roth IRA sooner rather than later to avoid annual impositions of the penalty.

Tax Return Considerations

Corrective measures applied to traditional IRA and/or Roth IRA contributions may require tax return reporting. Such reporting is discussed in various sources. Examples of such sources include IRS Publication 590-A, the Instructions to the Form 8606, and/or the Instructions to the Form 5329.

Conclusion

Excess contributions to IRAs and Roth IRAs happen. They are not an occasion to panic. They are an occasion for prompt, well considered action. Hopefully this article provides enough background for you to start your decision process and, if necessary, have an informed conversation with a competent tax professional.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.