“What are the limitations, if any, on making after-tax contributions to a 401(k) plan?”
ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with a financial advisor from Ohio is representative of a common inquiry related to after-tax contributions in 401(k) plans.
Highlights of the Discussion
After-tax contributions in a 401(k) plan can allow participants to maximize their contributions to retirement savings. Between 25-30 percent of 401(k) plans contain an after-tax contribution feature—but many are unaware of the possibility.
There are several considerations for making after-tax contributions to a 401(k) plan, including whether the plan allows for after-tax contributions and, if so, what limits apply. Additional considerations when making after-tax contributions include the actual contribution percentage (ACP) test; the IRC Sec. 415 annual additions test and top-heavy test.
After-tax contributions are subject to the ACP test—a special 401(k) test that compares the rate of matching and after-tax contributions made by those in upper management (i.e., highly compensated employees) to the rate made by rank-and-file employees (i.e., nonhighly compensated employees) to ensure the contributions are considered nondiscriminatory. Even safe harbor 401(k) plans are required to apply the ACP test to the after-tax contributions if any are made. Some may find this surprising, but—yes—despite the safe harbor design, the after-tax contributions are still subject to the ACP test [Treas. Reg. 1.401(m)-3(j)(6)]. If the plan fails the ACP test, a typical corrective method is a refund of after-tax contributions to upper management employees.
After-tax contributions are included in each participant’s annual additions test. Each plan participant has an annual total plan contribution limit of 100 percent of compensation up to $55,000 for 2018 and $56,000 for 2019, plus an additional $6,000 for catch-up contributions, under IRC Sec. 415 (a.k.a., the annual additions limit). All contributions for a participant to a 401(k) (e.g., salary deferrals, profit sharing, matching, designated Roth and after-tax) are included in a participant’s annual additions. If a participant exceeds his annual additions limit, a typical corrective method is a refund of contributions.
After-tax contributions are considered plan assets when testing whether the plan is top-heavy. If a plan is top heavy, meaning more than 60% of its assets are held by key employees (generally, the owners and officers of the business), then the plan must abide by minimum vesting requirements and meet certain minimum contribution requirements for the non-key employees.
The ability to make after-tax contributions to a 401(k) plan can have many benefits. But it is important to keep in mind they may be testy, but worth it in the right situations.