Whether we’re talking fashion or music or architecture or barber shops, it seems things that have faded from existence eventually come back around. See if this cycle looks familiar: cutting edge becomes status quo becomes so last week becomes so [insert decade] becomes retro becomes vintage.
According to recent press coverage spurred by an IRS notice, a rarely-used retirement plan feature that pre-dates even the leisure suit seems poised for retro status. However, as is so often the case when the popular press attempts to cover complicated financial topics, they tend to leave out critical details to make the story sound more plausible. This situation is no exception.
The feature in question is the after-tax employee contribution. Also referred to as voluntary contributions and post-tax contributions, these date back to well before the 401(k) plan even existed. Essentially, the provision allows employees to make after-tax contributions from their paychecks directly to the company-sponsored retirement plan. I know…it sounds similar to current Roth deferrals, but there are a number of critical differences, primarily dealing with the tax ramifications upon withdrawal. Whereas the investment gains on Roth deferrals are eligible for tax-free distribution if certain requirements are met, the gains on retro traditional after-tax contributions are taxed as ordinary income.
IRS Notice 2014-54 (published in September) provides mostly logistical guidance on the processing of distributions from retirement plans when the proceeds are bound for different destinations, including situations when the account being distributed includes both pre-tax deferrals and after-tax contributions. The press coverage is heralding this guidance as some new tax planning tool for high-income earners. While it may facilitate more streamlined processing of transactions, it isn’t exactly revolutionary and it isn’t quite so simple.
The most significant devil in the details relates to the testing requirement that applies to after-tax contributions. The Actual Contribution Percentage, or ACP, Test that normally applies to company matching contributions also applies to after-tax contributions, and is required even if the plan is otherwise a safe harbor 401(k) plan.
Since the goal of adding the after-tax provision is to allow participants to contribute more than the regular deferral limit ($18,000 + $6,000 catch up, for 2015), it is almost always just the highly compensated employees who can afford to utilize the feature. In that type of scenario, the plan is virtually guaranteed to fail the ACP test, causing the HCEs to receive refunds of some or all of the extra amounts they contributed. Not only does that make for some disgruntled HCEs, if the refunds are not made by March 15th of the following year, it could subject the sponsor to an additional 10% excise tax.
Alternatively, since non-safe-harbor matching contributions are also counted in the ACP test, the plan sponsor could make a very generous matching contribution in an effort to boost the non-HCE average to a level high enough to support the HCE after-tax contributions. The amount of the match would vary based on the expected contribution levels. As a general rule, however, if the intent is for some or all of the HCEs to maximize the after-tax contribution levels, this option could be quite expensive.
One benefit touted in the various articles on the subject is access to Roth IRA accounts for folks whose income would normally rule them out. However, assuming a plan allows for it, Roth accounts are available to all participants in a 401(k) plan, regardless of income. And, thanks to the fiscal cliff bill passed at the end of 2012, pre-tax accounts can be converted to Roth accounts inside the plan without the need to roll out to an IRA. A participant can roll the converted accounts to a Roth IRA – when leaving the job or reaching age 59 ½ - to avoid required minimum distributions. (For now…)
Thankfully, the leisure suit never made a comeback, and once we pull back the hood on adding after-tax contributions, we probably won’t be going back in time for them either.