Retirement plans can be great vehicles for tax deferrals – but they can also be giant headaches when it comes to reporting for tax reasons. This is because there are so many technical rules that the potential for making a mistake is fairly high if you don’t know what you’re doing (taxgirl PSA: your plan administrator is there for a reason, use him or her).
A common mistake in the world of retirement plans is, believe it or not, contributing too much in any year. Again, you should retain the services of a professional if you’re not sure what your limits are (or, at the very least, ring up your HR person).
If you’ve contributed too much in any year, the excess is taxable to you. To correct this mistake, your retirement plan may distribute the excess back to you (along with any associated income earned). Like most other distributions from a retirement account, a corrective distribution will be reported on a federal form 1099-R. However, a corrective distribution is not treated as a nonperiodic distribution from the plan and is not subject to the allocation rules. On the plus side, it’s not subject to an additional tax for early distributions but, on the downside, that money can’t be rolled over into another retirement plan. Be sure and familiarize yourself with the rules (or use the services of someone in the know).
Corrective distributions are coded on a federal form 1099-R as “8,” “B,” “D,” “P,” or “E” in box 7. If you made a corrective distribution during the year, make sure that you advise your tax pro accordingly. Sometimes mistakes happen and your form 1099-R might not properly reflect your corrective distribution – or the form might not be clear. This isn’t one of those things that you want to try and fix after the fact (although it can be done) so it’s best to make sure your tax pro has all of the pertinent info upfront.
Sometimes you’re not aware that you’ve contributed too much to your 401k until your tax program or professional tells you that Form W-2 for more than one employer excceds the deferral limit. If that’s the case, you need to take the excess out by April 15 each year (April 18th fo r2011) or you cannot take out the excess until you terminate your employment and receive all of the funds. Also it’s taxable even if you don’t have access, IRS Pub. 560 says it is taxed twice if not removed on time.
If you had more than one employer and you plan to go on extension for
2010 be sure to check your Forms W-2 to see if you are over the limit when adding the 401k amounts together. The limit is $16,500 or $22,000 if you’re over 50.
There isn’t much in the way of tax-deferred options . You can try to minimize taxes, though. In taxable brokerage accounts you might replace the target fund (if you’re comfortable with that allocation) with a combination of a tax-efficient equity fund and perhaps a muni bond fund (tax free in your state if available). With the muni bonds, though, you could get nailed by the AMT so be careful on that one. .
The other thing that happens, especially in small companies, is that the contributions become non-qualifying because the company doesn’t get enough participation from its lowest compensated employees. I’ve been seeing more of these as companies suspend or eliminate their 401k matching programs because of the economy, making it less attractive for employees at the bottom of the company’s pay scale to defer income.
I am trying to get a better understanding of excess deferrals vs. excess contributions. Per the instructions excess deferrals if not corrected by 4/15 are taxed in the year deferred and the year received (double taxation)…is this really correct? Can anyone direct me to a good refence to understand the difference between deferral and contribution?