In the year you retire from the military (or switch jobs in retirement), there is a booby-trap out there waiting for you. Over contributing to your employer provided retirement plan. Each year the IRS publishes the amount of wages you can defer into a 401(k), 403(b) and/or TSP. If you work for the same employer for the entire year, he or she will probably protect you from yourself and stop your contributions at the annual limit. If you have more than one employer there isn’t a mechanism to make that happen (your employer won’t know what you contributed to a different account). So, what happens if you contribute too much?
Fixing the Excess Contribution to your 401(k), TSP or 403(b)
First of all, you might not be able to fix the problem. The basic solution is to take the excess contribution out. But your employer is not required to allow you to take a corrective distribution to solve the problem.
If your employer does allow it, you want to take a corrective distribution and get the funds out. There are a few different scenarios (your boss may or may not offer any or all of these options).
- You withdraw the excess contributions and the earnings on them by 15 Apr of the year after the excess contribution was made.
- You withdraw the excess contributions and the earnings on them in the year the excess contributions are made.
- You withdraw the excess contributions and earnings after 15 Apr
How are Corrective Distributions Taxed?
To begin with, it’s important to understand that no matter what you do, the excess contribution will be taxable income in the year you made it. So here are the scenarios
- If you withdraw the excess contributions by 31 Jan, the contribution will show up as taxable income in the year you made it as you took the funds out and turned them back into taxable income. The earnings are taxed in the year you made the withdrawal and are not subject to the 10% early withdrawal penalty
- If you withdraw the excess contributions between 1 Jan and 15 Apr, the excess contribution will be taxable income in the year you made the contribution. The earnings are taxed in the year of distribution (the year after you made the contribution). Like the scenario above the 10% penalty doesn't apply.
- If you withdraw the excess contributions after 15 Apr, you take it in the shorts. First of all, you can only withdraw the excess contributions under normal distribution rules, or you’ll pay the 10% penalty on the distribution. Additionally, you’ll get taxed twice on the distribution. As you remember you were taxed on the excess contribution the year you made it, and you’ll get taxed when you take the distribution (unlike if you take the distribution by 15 Apr)
If the employer doesn't allow corrective distributions for excess contributions, you'll include the excess as income in the year you made the contribution and you'll be taxed on it when you take it out.
Pay Attention to This
You really need to pay attention to this in the year you retire (or change jobs). Nobody else is going to do it for you and the penalties, as you’ve seen, can be onerous.
Military Finances are Different
If you’re working with an advisor that doesn’t routinely work with the military, he or she may not even know that you have TSP or that it affects how much you can contribute to your 401(k). That’s why we think you should work with an advisor that deals with military and veteran unique financial issues each and every day. If you’d like to find out how we do that, use the button below to schedule a free initial consultation.
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