Its been a few years since the IRS provided such guidance, but now is a good time to revisit plan design focusing on after-tax contributions.
The majority of retirement plan participants contribute pre-tax dollars and receive a tax deduction for their contributions. However, some plans allow participants to make additional “after-tax” contributions over and above the deductible IRS limits ($19,000 for 2019), up to the annual defined contribution plan limit ($56,000 for 2019).
Historically, participants rolling over assets comprised of pre-tax and after-tax dollars needed to distribute such using a pro-rata share of both pre and after-tax funds, a complicated tax situation. For example, consider a participant with a $100,000 account balance, 80% representing pre-tax contributions and untaxed investment earnings, and 20% of after-tax contributions. If the entire account balance is rolled over and 80% of the balance is transferred to a traditional IRA and 20% to a Roth IRA, under the traditional rule, this would result in each account containing an 80/20 mix of pre-tax and after-tax dollars. Essentially, the transfer to the Roth IRA would not be tax-free as intended. Instead, 80% of the $20,000 transferred to the Roth IRA would be treated as taxable income in the year of the distribution. Conversely, 20% of the $80,000 transferred to the traditional IRA would be treated as basis of after-tax dollars.
Under the new rules the participant rolls over the pre-tax dollars to a traditional IRA and the after-tax contributions into a Roth IRA, creating a free conversion of after-tax participant contributions into a subsequent Roth IRA. However, this special treatment is only permitted if the total account is distributed. If the withdrawal were to represent a portion of the account, the old tax rule would apply and the account would be distributed on a pro-rata basis (pre-tax & after-tax dollars). Although these rules took effect January 1, 2015, the rules from Notice 2014-54 still apply.
Will these new rules open the flood gates for higher earners wishing to make after-tax dollars over and above the traditional 402(g) limit?
We’ve already seen the articles and the availability for a tax-free conversion will make it more appealing than ever to make after-tax contributions. A few considerations:
- The majority of employers don’t permit after-tax contributions to their 401(k) plan. The plan document must allow for this type of contribution and your plan may need to be amended.
- After-tax contributions are not tax-deductible. A scenario where it may make sense to make after-tax contributions is if you are already deferring the maximum pre-tax contribution allowed and wish to contribute additional contributions. In light of these new rules, the after-tax portion can be rolled into a Roth IRA and you enjoy favorable tax treatment.
- After-tax contributions are subject to the ACP test, a special compliance test for many qualified retirement plans that compares the matching and after-tax contribution rates of the highly compensated employees (HCEs) to the non-highly compensated employees (NHCEs). If the plan fails the ACP test, corrective action is required and most commonly refunds are distributed back to the highly compensated employees (HCEs).
In conclusion, there may be an appetite for higher earners to make after-tax contributions in excess of the pre-tax deferral limits, especially in light of the new tax conversion rule. However, the ACP test will dictate the threshold, if any, for these types of contributions.
Interested in learning more? Contact us
or your Plan Consultant/Plan Advisor to continue the discussion.