This post has to do with what you can contribute in the realm of the three most common types of retirement accounts, those being the traditional and Roth individual retirement accounts (IRAs) and 401(k) plans. Generally, people that rely on an IRA to save for retirement aren’t covered by a 401(k). Conversely, those that rely on a 401(k), which is primarily set up by a person’s employer, don’t generally contribute to IRAs. The purpose of this article is to dispel misunderstandings about these three most common types of retirement accounts because if you’re not careful, you can incur some negative tax consequences.

Maximum contributions for each type of account

For traditional IRAs, the maximum amount you can contribute to a single IRA is $6,000, but this maximum increases to $7,000 for those over 50 years of age. What’s interesting is that if you are married and your spouse has a traditional IRA, you may contribute to his or her account to the tune of $6,000 ($7,000 if over 50 years of age) per year, as well. You may contribute this maximum even if only one of you had taxable income. Therefore, if you and your spouse have one income, you can still contribute up to $12,000 ($14,000 if over 50), assuming both of you have separate IRAs. It should be noted that this annual contribution is limited to your amount of taxable income, so if your taxable income for the year was only $10,000, then you can’t contribute the full $12,000, assuming both of you are under 50 and each have a traditional IRA. In the foregoing case, you could contribute a full amount ($6,000) to one account, but to the other account, the max you could contribute would be $4,000. So, the maximum contribution per account is either: $6,000 ($7,000 if over 50) or your amount of taxable income. Assuming you are not covered by a 401(k), there is no adjusted gross income limit for who may contribute to a traditional IRA.     

Roth IRAs, named after the late congressman William Roth, allow for a maximum contribution of $6,000 ($7,000 if the account holder is over 50), but only if that amount does not eclipse the taxpayer’s total taxable income. In that case, the maximum contribution would be limited to amount of taxable income. This is the same rule associated with contributions to traditional IRAs. However, because Roth IRAs allow tax free growth inside the account, there is an adjusted gross income limit restricting who may contribute to a Roth IRA. The 2020 adjusted gross income limits are as follows: a) $206,000 married filing jointly; b) $139,000 single, head of household, or married filing separately and you didn’t live with your spouse during the tax year; c) $10,000 married filing separately and you did live with your spouse. So basically, if you’re filing under the two most common statuses, it’s $137,000 for single and $203,000 for married filing jointly. Note that if you’re above these limits, you can’t contribute to a Roth IRA at all.

Traditional 401(k) plans, which get their name from the portion of the Internal Revenue Code that deals with them [i.e. 26 U.S. Code § 401(k)] and are also called defined contribution plans, allow an employer to invest pre-tax dollars into a retirement account held by that employer for the benefit of the employee when he or she retires. Currently (tax year 2020) the limit on contributions for a 401(k) is $19,500. This means that if you are covered by a 401(k), this is the far superior option among retirement accounts because this limit applies regardless if you are single or married and offers the largest contribution potential. Even better, if you are over 50, you can make what’s called a catch-up contribution, which allows you to contribute an additional amount, up to $6,500 per year. As a result, if you’re 50 or older, you can contribute a maximum of $26,000 to your 401(k). There are slight exceptions to these rules in terms of whether an employer’s plan qualifies as a 401(k) along with special rules for highly compensated employees. However, these are outside the scope of this article, and most likely won’t be germane to an individual employee due to the fact that 401(k)s are employer managed accounts.

Bonus: Roth 401(k) plans combine the post-tax contribution, tax free growth benefits of a Roth IRA with the employer-held aspects of a traditional 401(k). Roth 401(k)s allow for the same contribution limits as a traditional 401(k), so just read the preceding paragraph if you’d like to know more about their contribution limits. However, to summarize, these accounts are akin to a Roth IRA, but held and managed by your employer, with higher contribution limits as compared to a Roth IRA.

What if you over-contribute to a retirement account in a given year?       

In the realm of traditional and Roth 401(k)s, over-contribution, which respectively means anything above the amount legally prescribed for that type of account, could cause the plan under which the account is held to become “unqualified,” which means no longer able to take advantage of preferential tax treatment of the funds contributed. Furthermore, in terms of the individual, excessive contributions which are not dealt with in the appropriate way once identified are subject to double taxation, once when the excess is contributed, and again on distribution. However, there is a simple fix to this problem, which is to simply distribute the excess contributions, along with any earnings thereon, to the plan participant, which would then be subject to taxation, as usual. Basically, distribute the excess contributions, showing them within the mix of income on the employee’s Form W-2 for the year the excess contributions were made. This corrective distribution must be made by the individual taxpayer deadline on or around April 15 of the year following a given tax year, with no allowance made for individual taxpayer extensions. However, note the catch up provisions for retirement, that is, those that generally allow individuals over 50 years of age to contribute more to their 401(k)s, are subject to a higher upper limit for contributions, and therefore contributions would only be excessive beyond this accelerated amount.

In a similar vein, over-contribution for traditional IRAs and Roth IRAs means a six percent penalty for excessive contributions above the limit for a given tax year. This six percent penalty is constant and accrues every year that the excess contribution stays in an individual’s account. Just as those for 401(k)s, a taxpayer can avoid the six percent penalty by withdrawing the excess contribution before the individual taxpayer filing deadline around April 15th, which does not change due to the individual filing an extension. Also like 401(k) contributions, limits for those over 50 years of age are higher and therefore what constitutes an excessive contribution will also be higher.

Conclusion

If you are interested in reading more about the tax treatment of retirement accounts see Publication 590-A, or the 401(k) Plan Fix-It Guide, 401(k) Plan Overview (for participants), or 401(k) Plan Overview (for employers).

Have questions or concerns about anything to do with IRAs or 401(k)s? Don’t hesitate to call Dino Tax Co today at (713) 397-4678 or email davie@dinotaxco.com. The phone consultation is always free, and we’re open seven days a week. Also, if you like us, show us on our Facebook page.