UPDATED 10.14.15

A recent IRS Notice 2014-54 has dozens of our clients asking us about converting after-tax contributions to Roth IRAs. In practice, there are very few plans that still have after-tax contributions available – most were written out of plans after the Tax Reform Act of 1986. But perhaps interest in this type of contribution is going to see new interest due to this new ruling. There are pitfalls to offering after-tax contributions, however, so Plan Sponsors should beware.

EMPLOYEE CONTRIBUTIONS

Company 401(k) plans and 403(b) plans may offer the Roth option for employee contributions in addition to the traditional pre-tax option. So an employee can contribute up to $18,000 in 2015 as pre-tax deferral, or Roth deferral or a combination of the two.

EMPLOYER CONTRIBUTIONS

Employer contributions to retirement plans, like matching contributions or other employer contributions are always done on a pre-tax basis. Some employees like the option to have tax diversification in their retirement accounts by having both Roth and pre-tax accounts.

AFTER-TAX CONTRIBUTIONS

For employees who want to contribute more than $18,000, and if the plan allows, the employee may be able to make additional after-tax contributions to the plan. These are different than Roth contributions and are held in a separate account from any Roth contributions that may be made to the plan. The after-tax contribution is allowed as long as the total of all contributions being made to the plan do not exceed the maximum contribution limit of $53,000 (in 2015).

TESTING CONSIDERATIONS FOR AFTER-TAX CONTRIBUTIONS

After-tax contributions are treated like a matching contributions for purposes of the Actual Contribution Percentage (ACP) test. Even if the plan has Safe Harbor provisions, allowing after-tax contributions would result in the plan requiring an ACP test. This may be a big problem for plans if only Highly Compensated Employees are the ones interested in making after-tax contributions.

ROTH ROLLOVER OF AFTER-TAX ACCOUNTS

Distributions from plans that include after-tax accounts and pre-tax accounts traditionally required a proration of the amount distributed from each source. But IRS Notice 2014-54 provided guidance that beginning in 2015, an employee could request a rollover of his after-tax contributions to a Roth IRA. The rollover Roth IRA would enjoy the tax free accumulation, avoid Required Minimum Distributions at age 70 ½ and have advantages for estate planning purposes as well. The new account would be subject to Roth distribution restrictions.

CLOSING

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