It is that time of year again when some employees will get notices from their employer stating they are getting money back from their 401(k) due to over contributing.  The typical reaction of most people is to check their contributions from the year before assuming they must have put in over $18,000, the current limit for those under age 50.  However, what most affected employees will find is that they did not go over the $18,000 limit.  If fact, many will be significantly restricted and will not get anywhere near the $18,000 contribution they expected. 

Unfortunately (or fortunately depending on your perspective), there are discrimination rules that govern 401(k) plans. The impact can be that regular employees with no ownership or power to change the direction of the company policies are limited in how much they can save for retirement in a tax-preferential way.  The good news is that there are a few alternatives outside the 401(k) to help those who are affected by these rules. 

The first options to consider are a traditional IRA and Roth IRA both of which provide more tax benefits then the other options listed below. A traditional IRA will most likely be an option for only a few higher income earners so make sure to see the phase out details.   Alternatively, the next option is to contribute to a Roth IRA, but there are limitations for higher income earners that can be found here.  Also consider having your spouse contribute to one of these plans if their employer does not offer a retirement plan.

Options with no income restrictions would include funding a non-deductible IRA or a non-qualified annuity.  While these two options are not tax deductible like a traditional IRA and are not tax free like the Roth IRA, they are tax deferred which is still a valuable benefit when compared to a regular taxable account. The tax deferred account will compound without the added drag of taxes each year, resulting in the ability to compound faster.  

In many cases, the problem of corrective distributions lies with the fact that many of the larger 401(k) providers only offer cookie cutter plan design options with their own product.  With some thoughtful conversation and exploration with someone that has experience in solving these problems, an alternative plan design may fix the corrective distributions.  If you have influence with your employer it might be time to ask them to consult a specialist in this area.

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