Recent IRS guidance has created a new interest in “after-tax” contributions as a plan provision because they can be used to maximize plan contributions and reduce future tax liabilities. Note: After-tax contributions are not the same as designated Roth contributions.
With proper plan design, after-tax contributions can be a valuable benefit to plan participants. Following is a discussion of some strategies and caveats.
After-tax Contribution Basics
After-tax contributions are not elective deferrals and therefore are not subject to the annual Section 402(g) maximum deferral limit ($18,000 for 2015). However, they are subject to the annual Section 415 limit ($53,000 for 2015; $59,000 for individuals age 50 or older eligible to make catch-up contributions of $6,000).
Conversion via IRR
A plan that permits both after-tax contributions and designated Roth contributions could be designed to also permit in-plan Roth rollovers (IRRs). This would allow participants to convert after-tax contributions into designated Roth amounts. Earnings converted with the after-tax amounts would be taxed in the year of the IRR. However, future earnings in the Roth account would not be taxed when distributed, provided they satisfy the qualified distribution requirements (generally, that the participant must be age 59½ or older and the designated Roth contributions must satisfy the five-year rule).
Example: Steve is age 60 and earns $225,000 in 2015. He makes $24,000 in designated Roth contributions ($18,000 + $6,000 catch-up), $20,000 in after-tax contributions, and receives a profit sharing contribution of $15,000. At the end of 2015, he converts his after-tax contributions plus earnings of $500 (a total conversion amount of $20,500) into designated Roth amounts. He will owe tax on the $500 of earnings in 2015. Steve now has an additional $20,500 in designated Roth money in his account. Assuming the additional amounts eventually become qualified distributions, Steve will have more tax-free income than if he made only designated Roth contributions to the plan.
Potential Issues
Including after-tax contributions in a plan can pose testing and administrative issues. “One-participant” plans (plans covering a business owner with no employees or a business owner plus spouse) face the fewest issues. Plans with nonhighly compensated employees (NHCEs) face the greatest number of challenges because nondiscrimination testing must be performed on after-tax contributions.
ACP Nondiscrimination Testing
Actual contribution percentage (ACP) testing is generally required for plans with employer matching contributions. After-tax contributions are also subject to annual ACP nondiscrimination testing. If a plan has both after-tax and matching contributions, they are tested together in one ACP test. Note that safe harbor 401(k) plans are required to perform an ACP test for any after-tax contributions that are made; safe harbor matching contributions are exempt from testing.
After-tax contributions are typically made by highly compensated employees (HCEs) who wish to contribute more than the annual Section 402(g) deferral limit allows. Since plans with HCEs often have nondiscrimination testing issues, such plans may face even greater testing issues if they allow after-tax contributions. One way to minimize the impact of after-tax contributions on nondiscrimination testing is to administratively limit the amount of after-tax contributions individuals can make for each plan year.
415 Limitations
IRC Section 415 rules limit the total amount that can be contributed to a participant’s account on an annual basis. Participants who make after-tax contributions need to be aware of that limit. Otherwise, they might run into a situation where an employer contribution causes them to exceed the annual Section 415 limit. If this limit is exceeded, the participant must receive a corrective distribution of the excess amount. After-tax contributions are generally the first type of contribution to be refunded.
Example: Ed is age 43. In 2015, he makes $18,000 of designated Roth contributions and $25,000 of after-tax contributions. After the end of the plan year, Ed’s employer makes a $12,000 profit sharing contribution to his account. Ed has exceeded the Section 415 limit of $53,000 for 2015 by $2,000 and must receive a $2,000 refund from his after-tax contributions (adjusted for earnings/losses). Refunded after-tax contribution amounts are not taxable, but the earnings associated with the refunded amounts are.
Like deferrals, after-tax contributions are also not included in the employer’s annual 25% deduction limit.
ADP Testing and Recharacterization
If plans subject to actual deferral percentage (ADP) testing fail to pass, sponsors typically either issue refunds to HCEs or make additional qualified nonelective contributions to NHCEs. A less commonly used ADP test correction allows refund amounts to be recharacterized as after-tax contributions and remain in the plan. Amounts recharacterized as after-tax contributions are subject to ACP nondiscrimination testing.
Permitting after-tax contributions could benefit HCEs who would otherwise receive an ADP refund. When pretax deferrals are recharacterized, the amount is taxable. However, earnings on the recharacterized amount are tax deferred. The recharacterized amount also can be rolled into a designated Roth account.
