Growing Interest in Voluntary After-Tax Contributions to 401(k) Plans

Voluntary after-tax contributions are just what it sounds like. These contributions are made in after-tax dollars and the taxes on the earnings are deferred until the year of distribution. Most 401(k) plans do not allow voluntary after-tax contributions because there has been little interest from participants. However, interest in after-tax contributions is growing due to a recent Internal Revenue Notice that allows the rollover of after-tax contributions from a 401(k) plan to a Roth IRA while the earnings on such contributions are rolled to a traditional IRA.

After-tax contributions are generally of interest only to highly compensated employees bumping up against the annual limit on deferrals and Roth contributions (for 2019, $19,000 / $25,000 if 50 or older), and whose income level prevents them from contributing to a traditional or Roth IRA. The only remaining opportunity for such individuals to save on a tax-advantaged basis is nondeductible IRA contributions (annual limit is $6,000 / $7,000 if 50 or older). In a 401(k) plan that permits voluntary after-tax contributions, such individuals may contribute on an after-tax basis up to the annual limit on all contributions (for 2019, $56,000 / $62,000 if 50 or older). Thus, if an individual elects pretax deferrals up to the annual limit of $19,000, there is still an opportunity to make up to $37,000 in after-tax contributions.

When the individual is eligible for a distribution, the after-tax contributions may be rolled to a Roth IRA and their future earning may escape all taxation. However, there is a significant limit on the ability of highly compensated employees to contribute after-tax because these contributions are included in the actual contribution percentage test (“ACP test”) that applies to matching contributions. Since non-highly compensated employees rarely make after-tax contributions, most plans will fail the ACP test if more than a few highly compensated employees make significant after-tax contributions. Failing this test forces the return of much of the after-tax contributions.

This information was developed as a general guide to educate plan sponsors and is not intended as authoritative guidance or tax/legal advice. It is not intended to provide specific legal, tax or other professional advice. The services of an appropriate professional should be sought regarding your individual situation.