Our company has a 401(k) plan that provides a matching contribution equal to 100% of the first 4% that each employee contributes. We set it up that way to ensure that our highly compensated employees (HCEs) can maximize their salary deferrals at the limit (for 2018 the limit is $18,500 for those under age 50 and $24,500 for those age 50 or older). The HCEs are always looking for ways to contribute as much as they can. I’ve seen a few articles suggesting that “after tax” contributions allow that. We already permit Roth contributions to be made, but I thought they were subject to the same limit as pre-tax deferrals.
Are after-tax contributions different than Roth contributions? If so, can adding an after-tax feature to the plan really allow the HCEs to contribute more each year?
The short answers are “yes” and “sort of.”
First things first. Let’s differentiate between after-tax and Roth contributions.
Depending on plan provisions, employee 401(k) deferrals can be made on either a pre-tax or Roth basis. With pre-tax deferrals, the participant gets an immediate tax deduction on the amount contributed, while Roth deferrals are not deductible up front. Both grow in the plan on a tax-deferred basis. The big difference is at the time of withdrawal. When a participant takes a distribution of pre-tax deferrals, the full amount of the withdrawal is subject to ordinary income tax. Roth deferrals, on the other hand, are distributed completely tax free as long as the participant is at least age 59 ½ and it has been at least 5 years since he or she first made a Roth deferral.
Other than the tax differences, Roth and pre-tax deferrals are combined and treated pretty much the same. Both are subject to the $18,500/$22,500 limit, and both are subject to the ADP test if the plan is not a safe harbor plan.
This contribution type is a whole different beast. Similar to Roth deferrals, after-tax contributions are subject to income tax in the year of contribution. They grow in the plan on a tax-deferred basis; however, at the time of distribution all the investment gains are taxed to the individual as ordinary income. The basis, i.e. the amount contributed, is not subject to tax at the time of distribution.
After-tax contributions are not considered to be “deferrals” and, therefore, are not subject to the $18,500/$22,500 limit. Instead, they are subject to the overall contribution limit, which is $55,000 for 2018. Another critical difference is that after-tax contributions are combined with company matching contributions for annual nondiscrimination testing purposes.
In theory, adding after-tax contributions to your plan would allow your HCEs to contribute an additional $36,500 to the plan each year. If you also add a provision to allow Roth conversions, they could then convert that entire amount to a Roth account to avoid paying tax on the earnings at the time of distribution. This practice is sometimes referred to as a Mega Roth, a Backdoor Roth or - if you're really into adjectives - a Mega Backdoor Roth.
The Fine Print
By now, you may have a sneaking suspicion that this all sounds too good to be true, which brings us to why we added the words “in theory.”
After-tax contributions do not fall under a 401(k) plan’s safe harbor status. That means they are subject to testing. What’s more, adding an after-tax feature also means the company matching contributions that were exempt from testing now must be tested alongside the after-tax contributions. The ACP test limits the HCEs to no more than two percentage points of compensation more than non-HCEs (on average). The fact that HCEs are often the only ones who can afford to make after-tax contributions means the plan is almost assured to fail the ACP test, resulting in those HCEs being refunded a significant portion of what they contributed in the first place.
And, the good news doesn’t end there. There is another test called the top-heavy determination. Without getting into the gory details, a plan is considered top heavy when more than 60% of the total plan assets are in the accounts of certain owners and officers. If a plan is top heavy, the company must ensure that all the non-owners/officers receive a minimum company contribution of 3% of pay even if they are not deferring. Safe harbor 401(k) plans that permit only deferrals and safe harbor contributions (the match in your situation) are usually exempt from this requirement. Since after-tax contributions are not considered deferrals or safe harbor contributions, their existence in the plan voids the top-heavy exemption.
As the saying goes, “If it sounds too good to be true, then it probably is.”