After-tax contributions, proceed with caution

There have been a lot of articles recently speculating that after-tax contributions are a loophole to allow highly compensated employees the ability to exceed the deferral limit. Although this may be an option for certain plan designs, this feature may create additional testing requirements that some plans, i.e. safe harbor plans, may currently enjoy exclusions from.

We often receive questions on what are after-tax contributions and how are they different from Roth deferrals. Roth deferrals are a way for you to contribute to your 401(k) plan without a tax deduction for those deferrals. The benefit is that these dollars (hopefully) will accrue interest in a tax-free manner. If distributed through a qualifying event, the interest will be distributed without taxation. After-tax contributions are only similar in the fact that participants do not receive a tax deduction when the salary is contributed to the plan. Earnings, on the other hand, are accrued in a taxable manner.

These contributions further differ when they are considered for testing purposes. Participants are set with a tax-payer deferral limit annually (the 402(g) limit) amongst any qualified retirement plan they are permitted to contribute to. For 2019, this is set at $19,000. Participants over the age of 50 can do an additional $6,000. Roth deferrals are subject to this 402(g) limit, however after-tax contributions are not. They are subject to the plan’s higher 415 limit (the limit of all aggregated contribution types) of $56,000. This is the main selling point of several articles promoting this feature. Like most things in life, there’s a catch. After-tax contributions are instead subject to Actual Contribution Percentage (ACP) testing. This test is traditionally preformed of employer matching contributions to ensure that highly compensated employees are not receiving a matching contribution disproportionate to non-highly compensated employees.

Therefore, plans that do not already offer a matching contribution are highly unlikely to pass this test. A vast majority of non-highly compensated employees are likely to contribute within the 402(g) limits and may not be interested in putting in deferrals greater than $19,000. If this is the case, any after-tax contributions put into the plan will fail ACP testing and will be returned to the highly compensated employees as a testing excess.

To further complicate matters, some plans are able to escape ACP testing all together. Safe harbor plans are designed in such a manner as to provide a minimum employer contribution (along with a few additional requirements) in order to avoid doing the ACP test. If after-tax contributions are permitted into the plan, safe harbor plans must complete ACP testing. If the test cannot pass, this may create refunds of not only after-tax contributions but safe harbor matching contributions. In addition, safe harbor plans will be subject to top heavy testing which may trigger further required employer contributions to the plan.

Additionally, many plans who add this provision want to know how much can be put into the plan as after-tax contributions with a passing testing. This is something that is not easily able to be predicted. As participants change their salary deferrals throughout the year, this will affect the amount of contributions that highly compensated employees can put in. Often, this limit cannot be accurately projected until after the end of the year. This creates a moving target as after-tax contributions are made through payroll throughout the year.

Sometimes when a feature sounds too good to be true, it is. Yes, after-tax contributions are permitted to go in at a higher dollar limit than Roth deferrals. However, this means additional plan testing and possibly plan refunds will apply. If refunds are not removed from the plan timely, additional penalties and tax consequences may apply. Additionally, participants who are not provided the opportunity to make after-tax contributions corrected through the Employee Plan Compliance Resolution System may receive a higher corrective contribution than a regular elective deferral. Before adding this provision to your plan, all consequences should be considered.

Lisa Melberg, Retirement Plan Compliance Consultant
Paul Erickson, Manager, Retirement Plan Consulting