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Anyway, she ended up contributing about 7,000 last year, well under the 12,000
allowed maximum, but a very high percentage of her total income.

She was just told by her employer that we are being sent a $1,250 check from her
401K plan, because she over-contributed in 2003. 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).

It sounds like you do understand it. It's common for a plan to have both a percentage and a $$ limit for contributions.

It sounds like Ira's premonition that this will be taxable in both 2003 and 2004 is correct. The explanation lies in IRS Publication 525. There is no penalty, per se, on excess contributions, but in some cases they get taxed twice, which is penalty enough. It looks to me like yours is one of those cases.

The excess is definitely taxable to you in 2003, and you need to amend that return to reflect the additional line 7 wages. See Pub 525 for the 2004 treatment. Assuming you do have to again pay tax on it in 2004, perhaps the employer will kick in a (taxable) contribution to your additional tax liability.

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