After Tax Contribution Considerations
Pentegra administers many 401(k) plans that include standard after-tax contributions—the non-designated Roth 401(k) type. And one thing we have learned is that after-tax contributions can create problems for the sponsor if the plan is not carefully designed and properly administrated.
In a 401(k) plan, standard after-tax contributions are amounts that a plan participant elects to set aside from his or her pay after the payroll department withholds taxes. The plan administrator deposits the after-tax contributions in a separate account within the 401(k) plan, where the amounts have the potential to grow on a tax-deferred basis. The amount of contributions and their associated earnings or losses must be separately tracked in order to optimize a tax efficient return of the account value.
The ability to make after-tax contributions to a 401(k) plan is becoming more popular and can have many benefits. They allow participants to maximize contributions to their plans and can lead to tax-efficient Roth conversions and further tax diversification strategies at withdrawal. Currently, between 25 and 30 percent of 401(k) plans allow for after-tax contributions. But it is important to keep in mind after-tax contributions can be “testy,” and they may not be right for every participant and every plan.
There are several considerations for allowing after-tax contributions to a 401(k) plan, including whether the plan permits after-tax contributions in the plan document and, if so, who can make them and what limits (IRS and/or employer-imposed) may apply. And when I say, testy, I mean, after-tax contributions are included in several key IRS compliance tests that apply to 401(k) plans, including the actual contribution percentage (ACP) test, the annual additions test and top-heavy test.
After-tax contributions are subject to the ACP test—a special 401(k) test that compares the rate of matching and after-tax contributions made by those in upper management (i.e., highly compensated employees or HCEs) to the rate made by rank-and-file employees (i.e., non-HCEs) to ensure the contributions are considered nondiscriminatory. Even safe harbor 401(k) plans, which typically automatically satisfy the ACP test for matching contributions, are required to apply the ACP test to any after-tax contributions that are made. Some may find this surprising, but—yes—despite the safe harbor design, the after-tax contributions are still subject to the ACP test [Treas. Reg. 1.401(m)-3(j)(6)]. If the plan fails the ACP test, a typical corrective method is a refund of after-tax contributions to HCEs, which is not popular.
After-tax contributions are also included in each participant’s annual additions test. Each plan participant has an annual total plan contribution limit equal to 100 percent of compensation up to an annual dollar limit, which is $61,000 for 2022, plus an additional $6,500 if eligible for catch-up contributions. All contributions for a participant to a 401(k) (e.g., salary deferrals, profit sharing, matching, designated Roth and after-tax) are included in a participant’s annual additions limit. If a participant exceeds his or her annual additions limit, a typical corrective method is a refund of contributions. Once again—not popular among the affected participants.
After-tax contributions are considered plan assets when testing whether the plan is “top-heavy.” If a plan is top heavy, meaning more than 60 percent of its assets are held by key employees (generally, the owners and officers of the business), then the plan must abide by minimum vesting requirements and meet certain minimum contribution requirements for the non-key employees. More hassle for the plan sponsor.
While it may be challenging, it is certainly not impossible to design and successfully administrate a 401(k) plan for almost any set of employee demographics to allow for after-tax contributions. It does, however, take careful upfront evaluation and collaboration with plan design and administration experts to avoid the potential downsides of after-tax contribution failures in order to reap their upside rewards.
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