Are you looking for a way to allow employees to contribute more to your company’s sponsored 401(k) plan? Do you have employees who would start contributing or increase their contributions to the plan if they had immediate access to their investment? Allowing after-tax contributions might be the solution that you are looking for.
Wait, our plan already allows for Roth deferrals, isn’t that the same as after-tax contributions? While Roth and After-Tax contributions are both made by the employee and are taxed in the year they are made, how the earnings on the two contribution types are handled is very different.
Earnings on Roth contributions can be tax free at the time of distribution if they meet certain requirements. First, the employee must have made their first Roth contribution at least five years prior to the distribution. Secondly, the distribution must be made due to the attainment of age 59 ½, disability or death. This can provide significant tax savings, especially for those concerned with paying higher taxes in retirement. The earnings on after-tax contributions, on the other hand, are indeed taxable at the time of distribution.
Why would someone make after-tax contributions?
Pre-tax and Roth elective deferrals are subject to an IRS annual contribution limit. In 2019, this limit will be $19,000. After-tax contributions are not subject to this same limit. They are only subject to a limit that looks at the total contributions made to a 401(k) account in a year. This limit includes employee pre-tax and Roth elective deferrals and employer matching and profit sharing contributions made to an individual’s account. In 2019, this limit will be $56,000.
Let’s say an employee contributes up to the $19,000 limit in 2018, receives a matching contribution of $2,500, and a profit sharing contribution of $1,500. The total of contributions into their 401(k) account for the year would be $23,000, $33,000 short of the $56,000 limit. That $33,000 difference is the amount that an employee could make in after-tax contributions! If the employee is 50 years of age or older, they can still make their catch-up contribution of $6,000, which does not count against any of the previously mentioned limits.
Does an employee have to wait until retirement to access that money?
Unlike, all other types of 401(k) contributions, after-tax contributions can be available for immediate withdrawal and do not require a distributable event to occur. Your plan document must allow for in-service withdrawals of after-tax contributions, and if it does not, may be amended to allow for such distributions.
It gets better!
After-tax contributions can be converted to Roth either in the plan or by rolling them over into a Roth IRA. The earnings would then become tax free once the previously mentioned requirements are met. Roth IRAs have an additional benefit of being exempt from the required minimum distribution rules that typically start at age 70 ½.
Are there any downsides to allowing after-tax contributions?
Uptake on after-tax contributions is typically made by highly compensated employees (HCEs). For testing purposes, after-tax contributions are treated like matching contributions.
If there are large disparities in contribution rates between HCEs and non-highly compensated employees (NHCEs), a plan may not pass its’ actual contribution percentage (ACP) Test, either resulting in additional contributions needing to be made to NHCEs or HCEs receiving a return of some of their contributions. Changes to your plan’s design may help reduce or alleviate the chances of ACP testing failure.
Are after-tax contributions right for our plan?
We recommend consulting with your retirement plan’s third party administrator to see if adding after-tax contributions to your plan will help you reach your objectives, how your plan can avoid ACP test failure, what potential amounts could be made in after-tax contributions by HCEs and what plan amendments may be required to allow for after-tax contributions and in-plan Roth conversions.
Jeremiah Perryman is a retirement compliance specialist with AmeriBen in Boise.