Many people have a definite goal to max out their 401k each year. The combined amount contributed by an employer and employee is $66,000 for 2023. The maximum amount for you to contribute to your 401k is $22,500. For individuals over 50, you are allowed an additional $7,500 to add to your retirement plan in the form of catch-up contributions.
A 401k is considered a good retirement vehicle for most, you are allowed to put away comparable sums of pretax dollars, along with employer contributions to help supplement your retirement and you can grow these funds in a system of tax deference. The major problem with 401k’s is that they have such a high tax implication when you start using the funds at retirement. The new tax implication for qualified retirement plans is IRMAA (income-related monthly adjustment amount). But that is a discussion for another blog coming soon! You also have penalties and restrictions if you decide to use the funds before 59 ½. Additionally, you are limited on the amount of pre-taxed dollars you can contribute annually.
A common problem with 401k contributions is the limitation to which you can contribute. Overfunding a 401k can lead to complicated tax issues. By the end of the calendar year if you have overfunded your 401k these funds have to amend your w2. The tax ramifications for leaving your overfunded monies in your 401k will result in a 6% tax for every year those funds sit in your qualified plan.
Not only are the excess funds to be amended on your w2 and considered as payment to you in the funded tax year but so too are all of the earnings that were made from those contributions. Under the Internal Revenue Code, 402(g) any deferrals excluded from taxable income in any given year, such as 401k, 403b Salary Reduction Simplified Employee Pension Plans, and Savings Incentive Match Plans for Employees may result in income tax liability to the participant unless corrected.
Most employers are pretty successful at getting these monies back to you before the end of the calendar year, but they do have till April 15th. If they are delayed in sending your excess contributions till the next year then they will have to file an amendment to your W9. If the excess amount is not returned to you by April 15, you could pay taxes on the amount twice—in the year the excess occurred, and in the year, it is returned to you. As quoted by IRC 402(g), “This April 15 deadline is not postponed by extending the filing of the employee’s federal income tax return”.
To help yourself and save you some level of stress it would be most prudent to follow up with your human resources department every year around October 15th. This is normally the time of year that human resources file their annual 5500 report, which is a report of 401k contributions. It also gives you and human resources plenty of time to make sure that you comply with the tax rules regarding 401k contributions within that year.
Regardless of what you decide to do with these funds, you are going to have to forego taxes. If I could explain it to you this way, for example, if your excessive contributions come to $10,000, based on your tax bracket you will have to pay taxes on that $10,000. Let’s assume your tax bracket is 34%; meaning you would have to pay $3,400 in taxes on the monies as income since it is coming to you as a current payment, and you will have $6,600 in actual cash. This $6,600 would be used as your annual payment to your Indexed Universal Life policy thus creating a tax-deferred, nonqualified, self-directed retirement plan.
Developing this planned allocation of funds is not established by the company nor is it funded by the company. This nonqualified retirement plan design is not subject to the Employee Retirement Income Security Act of 1974 (ERISA). Most nonqualified plans are deferred compensation arrangements, or an agreement by an employer to pay an employee in the future. The term “nonqualified”, means that the monies do not fall under (ERISA) guidelines. Which are the regulated tax guidelines for all retirement plans. These funds do not afford themselves the complication of being invested with pretax dollars and then taxed at some point and time in the future or when you have taken a distribution. These are monies that you have set aside and have designated as your retirement.
The difference between a nonqualified plan and a qualified plan is the restrictive guidelines of the government and abiding by the tax guidelines of the Internal Revenue Code. An Executive 162 Bonus Plan is a nonqualified plan designed for retirement. And yes, I understand we are not creating a 162 Bonus Plan, but the concept is the same.
162 Bonus Plan Tax Treatment
Any bonus paid is considered taxable compensation; the employer can deduct the bonus payments because they are deemed compensation to the executive that he or she, in turn, must recognize for tax purposes in the year in which the bonus (or premium) is paid. This is what we are doing by developing this designed plan. We are taking the excess funds that are returned to you from your overfunded 401k, after taxes which makes this a “Tax Sheltered Money Management System”, and are now available to place in an Indexed Universal Life Policy.
One of the main philosophies of retirement planning that I often convey to others is the idea of ‘the seed versus the harvest’. This basic farming analogy should give you a clear perspective on the benefits of having a tax-sheltered investment that can prove to be far more beneficial than your existing 401K. With the funding of an Indexed Universal Life Insurance policy, you are taking post-taxed dollars and placing them into a tax-deferred system and allowing the funds to grow exponentially. When the time comes to start taking distributions you can do so by borrowing the funds and you don’t pay taxes on borrowed money.
So, here are some of the advantages of an Indexed Universal Life policy versus your 401k:
It provides a much higher death benefit.
It has protection against market volatility and losses.
Marketable gains are tax-deferred or often taxed-sheltered
It can provide a tax-free distribution of funds at retirement.
Not restricted or penalized as to when you can take a distribution
Over the years insurance products have become more flexible and diverse in their fund allocation selections. No longer are the days where you plop money down and get a small return of 2-4%. Now some insurance products have performance values that can earn up to 15% and higher. The main type of insurance policy that does this is an Indexed Universal Life Insurance policy. Not only will you grow your policy at a competitive rate of return but you will also benefit from the policy having an investment floor of zero; meaning that the crediting strategy that you choose to allocate your money will not lose money in a market downturn. Allowing you to apply for these overfunded monies without incurring any losses.
Also, clear your mind of all the boring misconceptions about buying a life insurance policy that will only pay out at the time of your death. Life insurance is a valuable tool that is used for the system which I call the “Tax Sheltered Money Management System”. The value is how an indexed Universal life policy can continuously grow for you without losses. Each policy has an annual zero-sum game-type philosophy to it. This means that on the anniversary date of your policy, your allocation structure starts new. So, if you have a gain of 11% last year those earnings are locked in and cannot be affected by the new year. The new year starts at zero on day one of the new anniversary date.
Now I do understand that this is far from a 162 Executive Bonus Plan and you should too, but the concept and execution are the same. The fact that you do not have to have a contractual agreement between you and your employer on vesting or employment timetables. But you can, again, take those tax dollars and place them in a “Tax Sheltered Money Management System” that will continue to grow for some time. One caveat, the system doesn’t work well unless you can fund it for at least 10 years.
Although the policy may impose charges—surrender charges or market value adjustments, for example—there is no IRS penalty for taking a loan from the policy or making a cash-value withdrawal (provided the policy is not a modified endowment contract). You can access these funds at any time that you feel you may need them.
Special Note: The method used to avoid taxes from earnings growth from an Indexed Universal Life policy is by borrowing the funds. You can borrow the funds and continue to grow your policy at competitive rates that are comparable to mutual funds. These borrowed funds will not be considered as a distribution which is a taxable event. But if the policy is surrendered or lapses then all, funds that were borrowed will have a tax status change as a distribution which will become a taxable event. But why would you cancel the policy for as long as the policy has $1 in cash value in it at death it will pay out the death benefit and no taxes will be incurred. And your family will also inherit the death benefit.
These are some of the things we do at Ron at Forester Financial Partners; developing designed plans to help you grow into your ideal wealth design with little risk, small time management, and less stress.
What Happens if You Overfund your 401k
