Intentionally paying tax on 401K excess contributions to take advantage of employer matching?

Question

This is a little bit of a twist on another question that has been asked in this community. My wife started a new job in February, after which she had contributed about $2,000 through her previous employer's 401k, which did not have a matching policy. The new employer has a generous 50% matching policy. Originally we were going to manually cap out her contributions through the new employer at $17,500, in order to avoid the excise tax, but maximize the $8,750 in matching contributions.

But, since 50% free money is much higher than 6% tax, I'm realizing that it might make sense to contribute a full $19,500 through the new employer to take advantage of an additional $1,000 in matching, even though it would mean the excise tax and being double taxed on the amount. If I assume 25% tax rate, that would be $500 excess tax, plus the 6% excise tax of $120, is $670, which is still less than $1,000 in free money. Am I missing something here?

Note that the new employer does not know or care how much she contributed to the previous employer (we asked in the context of having them systematically limit her contributions this year), And the previous employer will not allow her to remove the $2,000 contribution.

Answer 1

I think this question really boils down to:

If I over contribute to my 401k across multiple companies, can I choose which company to undo the excess contribution from?

In your case, obviously you'd prefer to undo the contributions from the first company. This article suggests that you can choose:

You can take the corrective distribution from any account. ... Likewise, when two or more employers are involved, you can take the corrective distribution from the plan where you made the earlier contribution — if you can get the former employer to cooperate. The key is to get your total down to the limit with a distribution from some account by April 15.

Now if we assume that you can remove the first contribution, you need to figure out how to do it because you mentioned the first employer is not cooperating. This article suggests that to undo an over contribution you have another avenue:

If you overcontributed to your 401(k) plan—that is, you contributed more than the annual maximum set by the IRS—you should notify your employer or the plan administrator immediately. Ideally, this notification should be provided by March 1 of the year after the excess deferral contribution, as it's technically known, occurred.

If your employer isn't cooperating, you could try the plan administrator. It's the administrator's job to handle these sort of requests, and assuming they do, the company will have no choice but to issue a corrected W2.

Side Note: If you're going to do this, you might want to wait until Jan 1 next year before contacting the first company's plan administrator. I'm not sure they would be OK undoing a future over-contribution that hasn't happened yet, and I wouldn't recommend "knowingly" over-contributing on purpose either, because you may be stepping over a legality line. But, once the over-contribution has occurred, regardless of what caused it, the administrator would have to oblige your request, because if they don't then I assume they would be the ones breaking the law.

Answer 2

First off, the 6% excise tax only applies to IRAs, and also applies every year the over contribution is in the account, until you correct it. Since you're talking about a 401k, this does not apply. [Some sites mention 6% taxes for over contributing to a 401k but I can't find that in the IRS documents. The only mention I see is regarding IRAs. If someone offers a source I will edit.]

Now, there are really two possible ways this works out:

1. Your wife over-contributes $2,000 for the year and then withdraw the contribution and any earnings prior to April 15th of the following year. Taxes are paid on the $2k like normal income. However, since she withdrew the contribution her employer will most likely reverse any matching funds. In this case, $1,000. It is almost like you never made the over-contribution.
2. Your wife over-contributes $2,000 and keeps it in the account "forever" (or so you think). But, the IRS contacts the employer and tells them that they are not following the "Qualified Plan" rules. From the IRS:

Also, if the entire deferral is allowed to stay in the plan, the plan may not be a qualified plan.

"Not qualified" is IRS speak for "no tax breaks". Rather than make all employees pay taxes on their 401k contributions, the employer will force you to reverse the contribution. If this happens then you will pay income taxes on the money twice, once for the original contribution and once for when the money is returned to you (since it doesn't get added to the cost basis). With a 25% tax bracket this works out to $2,000 * (0.25 * 2) = $1,000 due in taxes. On top of that, since the money wasn't a qualified contribution the employer will most likely still take out their matching funds. So you lose another $1,000.