Recharacterized elective contributions and ACP Testing

[buckaroo]

I have a client that wants to add an after-tax provision to their plan document.  One of the reasons for this is so that the HCEs who are due corrective distributions (due to an ADP test failure) can have them recharacterized as after-tax employee contributions.  I wanted to do some research before I consulted with them and I ran across 401(m)-2(a)(4)(ii).  It says: 

Quote

 

ii)Recharacterized elective contributions.—

Excess contributions recharacterized in accordance with §1.401(k)-2(b)(3) are taken into account as employee contributions for the plan year that includes the time at which the excess contribution is includible in the gross income of the employee under §1.401(k)-2(b)(3)(ii).

 

 

Upon reading this, it appears that if a ptp has a pre-tax elective deferral recharacterized to an after tax, that the after-tax contribution is tested in the ACP in the year in which the recharacterization is performed.  (This is very surprising to me.)  To clarify, calendar year 2016 test.  ADP fails and recharacterization occurs in 2/2017.  From my reading of the above, it appears that the recharacterized amount would be include in the 2017 ACP test. 

1) Do I have this correct? 

2) What if the participant terminates prior to the 2017 plan year?  Does the participant have compensation for ACP purposes?  Does the recahracterized after-tax contribution count as compensation?  Eligible compensation?  How does this get included for ACP purposes?  (I would not include this person in the ACP test if they did not have eligible compensation and work during the plan year.) 

3) Same issue as #2 above, but let's say he works 1 day in the 2017 year and earns a very small amount. 

4) If the elective deferral is a Roth elective deferral, I would think that this changes the issue and the recharacterized amount would then be included in the 2016 test as it was taxed in 2016. 

Any help is greatly appreciated. 

 

 

 

[ETA Consulting LLC]

I do not believe that is correct.  I believe recharacterizations must occur within 2-1/2 months after the plan year end and would be taxable for the year they would've been included in income had they not been deferred.  In your case, they would be taxable in 2016.

Good Luck!

[Tom Poje]

if you recharacterize, the deferrals are treated as after tax, so you get a 1099r and you pay taxes - in your example - 2016, the year they "took place"(as ETA indicated). otherwise, by your logic, such contributions would be ignored entirely in 2016, but then show up in 2017 in testing!

 

by the way, let's say your plan has a last day rule or hours requirement for match. normally, people who fail such requirements would not be included in ACP testing, but once you add after tax, since those people could have made after tax at any time during the year, they are included in ACP testing, which of course puts more 0s on the test, making harder to pass ACP testing. plus you have move an amount from ADP test to ACP from HCEs, making it harder to pass ACP testing, so you might not be accomplishing anything with such a strategy.

[buckaroo]

Thanks for your replies.  However, I still think that I am correct in my reading of the ACP testing.  After I took a look at your replies, I took another look at the EOB - Chapter 11 Section VII (Page 11.119).  This section directly from EOB seems to support the notion.  Please see the below: 

Quote

 

1.d. Treatment of excess contributions from the ADP test recharacterized as employee contributions. An HCE’s excess contributions under the ADP test that are recharacterized as employee contributions are included in the ACP test as part of an HCE’s contribution amount. See Treas. Reg.§1.401(m)-2(a)(4)(ii). Treas. Reg. §1.401(m)-2(a)(4)(ii) provides that the recharacterized contributions are taken into account as employee contributions for the plan year that includes the time at which the excess contribution is includible in the gross income of the employee under Treas. Reg. §1.401(k)–2(b)(3)(ii). Since the recharacterized contributions are includible in gross income for the plan year following the plan year in which they were determined to be excess contributions under the ADP test, this means that the employee contributions are included in the ACP test for a different plan year from the plan year in which the recharacterized contributions had originally been included in the ADP test. For more information on the recharacterization process, see Section VIII, Part H, of this chapter.

 

1.d.1) Example. For the 2018 plan year, 3 HCEs are determined to have excess contributions. The plan provides for recharacterization. In accordance with Treas. Reg. §1.401(k)-2(b)(3), the excess contributions are recharacterized as employee contributions in the first 2½ months following the close of the 2019 plan year. Pursuant to the Treas. Reg. §1.401(k)-2(b)(3)(ii), these amounts are taxed to the affected HCEs in the same manner as if the excess contributions were distributed at that time. Pursuant to Treas. Reg. §1.401(k)-2(b)(2)(v)(A), these amounts are includible in gross income in 2019. Accordingly, the recharacterized contributions are taken into account as employee contributions for purposes of running the ACP test for the 2019 plan year.

Note - different result in pre-2008 plan years. In pre-2008 plan years, distributions of excess contributions made within the first 2½ months after the close of the plan year were includible in income for the taxable year in which the elective deferrals were made (using a FIFO method of accounting). In the above example, if those rules were still in effect, the income inclusion for the HCEs would have been in 2018, rather than 2019, so the recharacterized contributions would have been included in the 2018 ACP test.

 

This indicates that the amount is taxable in the year in which it was re-characterized and should be included in the following year's ACP testing. 

Please take a look and feel free to comment.  Any comments are greatly appreciated. 

[Tom Poje]

could be, that would be different from what I learned years ago. (and this is also something not found in previous editions of the book at least before 2013, so not sure when this was 'noticed')

if you copied and pasted, there must be a typo, because it says

"after the close of the 2019 plan year" and it must mean 2018 plan year.

 

[buckaroo]

Yes Tom, I believe it is a typo as well as it was a direct quote. 

Anyone else have thoughts on this one? 

[CuseFan]

I think you are correct, and this is contrary to how certain "veterans" in the industry (self included) were brought up. Although, just thinking conceptually, this does make sense. You have an HCE excess in 2016, it becomes taxable in 2017, but instead of distributing it you allow it to remain in the plan as an after-tax contribution - in essence, you have allowed them to re-contribute it to the plan, so why wouldn't it be ACP tested in 2017? Unless you have an unusual design or testing results, I wouldn't anticipate recharacterized deferrals being able to satisfy ACP testing with existing match, but who knows?

[Tom Poje]

yes and no it makes sense

I could make an IRA contribution early in 2019 but have it apply for 2018 tax purposes.

I am surprised the same rule doesn't apply that works with excess deferrals, that if you get things taken care of by 3/15 they are taxed in 2018 (in the example cited above)

They are saying they sort of work like excess contributions, since taxed in 2019 they are included in 2019 testing because they never leave the plan

[buckaroo]

Any thoughts on questions 2-4 in the OP? 

[ETA Consulting LLC]

When the rules changed to provide that all corrective amounts are now taxable during the year distributed, including those within the 2-1/2 months following the close of the year, the Treasury failed to trace the Regulations on recharacterizations.  Anytime this happens, I typically refer to my plan's language to see now they handled it. 

I'm not suggesting that "Follow the plan and not the Regulations" because the rule is quite the opposite.  But, what I generally do is to look for various ways something is being written in order to enhance my ability to interpret.  "Case in point would be a discussion we had last year about the calculation of loan limits when several loans are taken during a year".  But I digress. 

For the issue in question here, my BPD reads: Recharacterization must occur no later than 2½ months after the last day of the Plan Year in which such Excess Contributions arise and is deemed to occur no earlier than the date the last Highly Compensated Employee is informed in writing of the amount recharacterized and the consequences thereof. Recharacterized amounts will be taxable to the Participant for the Participant's taxable year in which the Participant would have received such amounts in cash had he/she not deferred such amounts into the Plan.

Good Luck!

[Tom Poje]

buckaroo -

I think your point about the fact if the person quit in 2018 shows the ludicrousness of using the amounts in 2019. It simply can't be done, unless you had an additional provision that said "You use what ever % it amounted to in the prior year". but then you have the issue of someone who didn't quit. how do you get around treating 'everyone the same'?

so, if anything, I would say, the language in the regs is poorly written (or not intended to mean what it may say, and certainly no one has interpreted it that way up to this point in time that I am aware of) as it makes no sense if it requires to use such amounts in the following year.

[Tom Poje]

I did ask Sal about the wording and he responded

I asked him about it and at first he said no typo, so I tried again and this time:

 

"Oh I think I see where the typo is now. I thought you were referring to the reference to the 2019 plan year at the end of the example It's the reference in the middle of the paragraph. I will post an errata item at my website and correct for next year's edition."

...........................................................................................................

 

I thought of another example that really makes no sense. (Please, no comments about the rest of the regs making no sense, at least there is some reason for them)

Fred, a non owner only made 90,000 in 2018.

so now I get to treat these after tax amounts in the ACP and benefit the HCEs because the NHCE average goes up, with contributions there were attributable to an HCE when made, but now are treated as an NHCE because, well,  that is the "penalty" imposed  on an HCE for deferring too much in such cases.