Pros/Cons of After tax contributions?

[kwalified]

A small S.H. 401(k) is considering adding an after tax option in order to go above and beyond the 415 limits. There recently has been a lot of press regarding the ability to convert these contributions to ROTH IRA down the road. What are your thoughts on adding such an option to a plan?

[401king]

I think I'm right in believing that after-tax contributions are only for those employee deferrals above the 402(g) limit; an individual cannot have contributions greater than the 415 limit.

[Tom Poje]

I think the comment above is thinking of catch up contributions and not after tax contributions.

I would run far away from such thoughts, far, far away (my opinion, of course)

the following was drilled into my so called brain years ago

a couple of issues

Strike One

from the IRS website (the numbers are a bit dated, but nothing has changed)

http://www.irs.gov/Retirement-Plans/Fixing-Common-Plan-Mistakes---Failure-to-Limit-Contributions-for-a-Participant

A qualified 401(k) plan must provide limits for contributions and forfeitures allocated to a participant’s account. The total of employer contributions, employee contributions and forfeitures allocated to a participant’s account cannot exceed the limits under §415© of the Internal Revenue Code.
Section 415© generally provides that during a limitation year (the calendar year, unless another 12-month period is specified in the plan), the total of employer contributions, employee contributions and forfeitures made for a participant cannot exceed the lesser of:
1) $40,000 or
2) 100% of the participant’s compensation.
Section 415(d) of the Code provides for a cost of living adjustment to the $40,000 dollar limit. In 2007, the dollar limitation was $45,000.
For 401(k) plans, the types of contributions subject to the limit include: (This is what you were trying to get around)
elective contributions (pre-tax or Roth);
after-tax employee contributions;
employer matching contributions; and
employer profit-sharing contributions.

let's pretend that wasn't the issue

Strike 2

after tax contributions are used in the ACP test - in a small plan the test would probably fail. and since everyone could make them, you can't exclude anyone from the ACP test (even those who might have terminated with less than 500 hours, if the plan didn't provide for match for terminees)

Strike 3

even if the plan was a safe harbor, you still have to test after tax 1.401(m)-3(j)(6)

This ump says you are outta here.

[Bill Presson]

Here's what is generating this. I got a question about it yesterday, so I had to spend some time last night reading up.

http://www.irs.gov/pub/irs-drop/n-14-54.pdf

This notice allows participants to split a distribution between a regular IRA and a Roth IRA. That will allow after tax money to be rolled to an IRA.

Here's an article from Forbes (there are others touting the same thing).

http://www.forbes.com/sites/ashleaebeling/2014/09/19/irs-issues-401k-after-tax-rollover-rules/

The ACP testing issues are still a big problem.

But for a small plan or even a solo 401(k), looks like it might be an option.

[kwalified]

Thank you for the links Bill, this is what I am looking for. Not sure how ACP would apply if the plan is safe harbor, but it looks as if it would be a nice option to have for those that want to go beyond 402(g).

[Lou S.]

Thank you for the links Bill, this is what I am looking for. Not sure how ACP would apply if the plan is safe harbor, but it looks as if it would be a nice option to have for those that want to go beyond 402(g).

There are plenty of safe harbor formulas that get you ADP relief but NOT ACP relief.

Voluntary after tax contributions as I understand it are always subject to ACP testing but maybe I'm missing something.

[Tom Poje]

not missing anything. I noted the cite above - 1.401(m)-3(j)(6)

so in a safe harbor plan if everyone defers and gets max match, then the most after tax an HCE could get is 2%.

(assuming there is not another HCE who is not deferring)

if one or more NHCEs don't defer it will drop e.g. if there are only 4 NHCEs and only 1 defers and gets the basic match (4%) (and you include those amounts in testing then that would leave an ACP avg of 1%. The owner has received 4% match so plan fails ACP test - so you can't have any after tax.

so you don't include the safe harbor match in testing. now the ACP avg is 0%, so you can't have any after tax

if 2 of the 4 NHCEs defer and you include the match in testing you have an avg of 2%. the HCE is at 4%, so that is enough to pass, but leaves no room for after tax

[Tom Poje]

one additional thought, I think an after tax contribution would also negate "get out of top-heavy" free card (assuming no profit sharing contributions were made)

[kwalified]

I think the comment above is thinking of catch up contributions and not after tax contributions.

I would run far away from such thoughts, far, far away (my opinion, of course)

the following was drilled into my so called brain years ago

a couple of issues

Strike One

from the IRS website (the numbers are a bit dated, but nothing has changed)

http://www.irs.gov/Retirement-Plans/Fixing-Common-Plan-Mistakes---Failure-to-Limit-Contributions-for-a-Participant

A qualified 401(k) plan must provide limits for contributions and forfeitures allocated to a participant’s account. The total of employer contributions, employee contributions and forfeitures allocated to a participant’s account cannot exceed the limits under §415© of the Internal Revenue Code.

Section 415© generally provides that during a limitation year (the calendar year, unless another 12-month period is specified in the plan), the total of employer contributions, employee contributions and forfeitures made for a participant cannot exceed the lesser of:

1) $40,000 or

2) 100% of the participant’s compensation.

Section 415(d) of the Code provides for a cost of living adjustment to the $40,000 dollar limit. In 2007, the dollar limitation was $45,000.

For 401(k) plans, the types of contributions subject to the limit include: (This is what you were trying to get around)

elective contributions (pre-tax or Roth);

after-tax employee contributions;

employer matching contributions; and

employer profit-sharing contributions.

let's pretend that wasn't the issue

Strike 2

after tax contributions are used in the ACP test - in a small plan the test would probably fail. and since everyone could make them, you can't exclude anyone from the ACP test (even those who might have terminated with less than 500 hours, if the plan didn't provide for match for terminees)

Strike 3

even if the plan was a safe harbor, you still have to test after tax 1.401(m)-3(j)(6)

This ump says you are outta here.

Ahhh, after tax deferrals go against 415/402(g). . Never had a plan that used after tax option.

[John Feldt ERPA CPC QPA]

I think the after-tax concept would be the most helpful for an owner-only plan (no employees) where the owner has net earned income of say about $60,000. They can contribute a deferral of $23,000 and then contributed an after-tax contribution to get the rest of the way to the 415 limit.

The deduction limit would limit any pre-tax employer contribution to a low amount (25% of 415 comp or NESE), whereas the after-tax employee contribution is not a deduction so it's not held down by the 25% deduction limitation. Compensation still needs to be high enough as the 100% of compensation 415 limit still applies.

[Lori H]

Why not just defer ROTH 401(k)? It's after tax.

[John Feldt ERPA CPC QPA]

If the owner/sole proprietor wants $52,000 as Roth, the deferral limit only allows $17,500 as Roth. Employer contributions are subject to deduction limits, thus the after-tax employee contribution (an amount separate from the deferral) can get them $52,000 Roth (after converting the after-tax contribution).

[austin3515]

Go with in-plan roth conversions in that scenario.

I see no purpose for it in a qualified plan at all. No one in their right mind should be doing after-tax unless they max out on Roth. And why add after-tax if you're not already allowing Roth.

So maybe it's a good idea if you have an NHCE base that is maxing out their roth who want some additional opportunities, But exclude the HCE's from the opportunity. Never say never, but I guess that's the only scenario I can think of. And to Tom's interesting point, only then if the plan is not top-heavy,.

[Lori H]

If a plan is Top Heavy but satisfies the Top Heavy requirement by being a Safe Harbor 401(k) and the plan already has ROTH option in it, what benefit if any, would there in having an After Tax deferral option?

[austin3515]

^{There are new opportunities for rolling after-tax balances to Roth IRAs that did not exist last year (as discussed above) in some of the links.}

[Earl]

I think after tax makes sense for DB + DC Single Participant Plan. Can conplete 415 in DC with after tax and then convert.

[mbozek]

Making AT contributions to a 401k plan has become a popular topic on investment websites for individual investors who are looking to maximize roth contributions. Usual procedure is to make AT contributions and then if plan permits take an annual distribution of AT funds if plan has designated AT account as a separate contract under IRC 72d or e. Taxation will be limited to earnings attributable to AT amount. Purpose is to max out contributions to a Roth by also making annual contributions to a Roth IRA. I am not saying its a good idea but only that it is generating a lot of interest by investors believe that they will save taxes by making annual inservice conversions of AT funds to a roth IRA.

[Guest John P.]

Great comnversation....and, my question only applies to an individual business owner (no common law ees).

Provided the plan docs permit, individual could put in an after tax contribution and then immeidately (like the following day) do an in-plan conversion to Roth dollars, correct? If that is done, then the funds (which have already been taxed anyway as an after tax contribution) and any growth from investments would be tax free, correct? Meaning that when business owner eventually shuts down business, they could rollover (with the new ruling) the "after-tax" contributions and earnings into a Roth IRA? Do I have this right?

Thanks everyone.