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According to my wife's employer, she over-contributed even though she only put in 7,000, because the plan has a maximum allowed percentage-of-income contribution, which she exceeded. (I'm assuming I understanding all this correctly). Apparently this over-contribution was just discovered.

There are some tests that have to be done on the entire employee population. The contributions among the highly compensated can't be too much higher than the non-highly compensated (on a percentage basis). If they are, some amount has to be refunded to the employees.

Also, the plan itself might have a percentage of income limit on the contributions. This used to be required a couple of years ago. Congress changed the law to allow higher percentages of income to be contributed, but old plans had to be amended to allow these higher contributions. Some haven't been.

So now I am wondering what is best to do with this check for $1250 that is supposed to be coming.

I'd suggest putting into your bank. Framing it and displaying it in your living room probably isn't a good idea.

We wanted to leave it in the 401K, but apparently can't. My understanding is that we will have to pay taxes on it in 2004, plus some sort of penalty for over-contributing and/or withdrawing early (since we are much younger than 59 years or whatever we would need to be to withdraw from the plan without penalty).

It is taxable income, but I don't think there are any penalties associated with it if you report it as income on your 2003 (yes, last year's!) return. Basically is is just as if you never made the contribution. This probably involves amending your 2003 return.

Another wrinkle is that the distribution should also include some earnings on the excess contribution. Since you received those earnings in 2004, that portion will be taxable on your 2004 return.

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