Since the Internal Revenue Service (IRS) loosened the distribution restrictions on after-tax and pretax amounts when rolling over funds from a 401(k) plan, many advisors and consultants are encouraging participants to consider making additional traditional after-tax contributions to their 401(k) plans, and in turn, encouraging plan sponsors to add traditional after-tax back to their plans.
After the IRS Notice (2014-54), a participant can now specifically direct the pretax and after-tax amounts of any distributions or conversions without the limitation of having to take a proration of pretax and after-tax amounts.
Recent articles on the subject point out that a participant could potentially deposit substantial after-tax contributions above the individual deferral limit of $18,000 (for 2015). The after-tax contributions would be limited only by the Section 415 annual addition limit of $53,000 (or $59,000 for those over age 50). This 415 limit includes all contributions to the plan including pretax deferrals, Roth deferrals, after-tax contributions, and all employer contributions.
This could mean significant savings and future tax advantages for the participant. If the plan allows for in-service withdrawals or in-plan Roth distributions, employees could then choose to annually distribute the after-tax contributions to a Roth account, thus sheltering any earnings on the contribution from further taxation, instead of letting the earnings continue to grow inside the pretax account to be later subject to taxation upon withdrawal.
This sounds fantastic for the participant, but it feels too good to be true. What is missing? What isn’t being considered? How do these potentially large contributions affect the plan?
As a compliance manager, I believe that the largest missing component in this discussion is the nondiscrimination testing. Some articles I’ve seen on the topic mention nondiscrimination testing, and some don’t. But even when they do, it’s an afterthought. All 401(k) plans are subject to some form of testing.
Where might large after-tax contributions make testing difficult?
It stands to reason that the participants with the ability to take advantage and be most interested in making additional large after-tax contributions would be highly compensated employees (HCEs). Whether an HCE because of compensation or because of ownership and attribution (such as the spouse of an owner not needing the wages), this is the group most likely to be able to fund these contributions.
Many 401(k) plans need to be tested for nondiscrimination of the average deferral rate (ADR) and average contribution rate (ACR) of HCEs as compared with the ADR and ACR rates of non-highly compensated employees (NHCEs). They are referred to as the 401(k) ADP and 401(m) ACP tests. The 401(k) ADP test assesses pretax and Roth contributions, while the 401(m) ACP test looks at the employer matching contributions and employee after-tax contributions.
Let’s work an example. If it is true that the participants who will likely take advantage will be the HCEs, these larger after-tax contributions could negatively affect the results of the ACP test.