Most 401(k) plans do not allow voluntary after-tax contributions due to little interest from participants in the past. However, interest in after-tax contributions has been growing recently following an Internal Revenue Notice. The notice allows the rollover of after-tax contributions from a 401(k) plan to a Roth IRA while the earnings on such contributions are rolled to a traditional IRA.
Voluntary after-tax contributions are contributions made in after-tax dollars. The taxes on the earnings are then deferred until the year of distribution.
Who’s Likely to be Interested?
After-tax contributions are generally of interest to highly compensated employees bumping up against the annual limit on deferrals and Roth contributions (for 2019: $19,000 / $25,000 for those 50 or older). These income levels’ of these indivudals prevents them from contributing to a traditional or Roth IRA.
The only remaining opportunity for such individuals to save on a tax-advantaged basis is non-deductible IRA contributions (annual limit is $6,000 / $7,000 for those 50 or older).
In a 401(k) plan that permits voluntary after-tax contributions, such individuals may contribute on an after-tax basis up to the annual limit on all contributions (for 2019, $56,000 / $62,000 for those 50 or older). Thus, if an individual elects pre-tax deferrals up to the annual limit of $19,000, there is still an opportunity to make up to $37,000 in after-tax contributions.
When the individual is eligible for a distribution, the after-tax contributions may be rolled to a Roth IRA, and their future earning may escape all taxation.
Key Considerations for Allowing (or Not Allowing) These Contributions
However, there is a significant limit on the ability of highly compensated employees to contribute after-tax, because these contributions are included in the actual contribution percentage test (“ACP test”) that applies to matching contributions. Since non-highly compensated employees rarely make after-tax contributions, most plans will fail the ACP test if more than a few highly compensated employees make significant after-tax contributions.
Failing this test forces the return of much of the after-tax contributions, so practices should consider the make-up of their team and compensation details before allowing these contributions to be part of their 401(k) plan.
To learn more about this topic, plan sponsors are encouraged to reach out to Curi Capital’s Retirement Plan Solutions team at 984-202-2800.
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