Michael A. Webb, vice president, Cammack Retirement Group, answers:
The Experts have seen similar articles promoting this approach, primarily as a tax-planning strategy for the wealthy and/or those nearing retirement. The strategy is to make additional after-tax contributions to one’s retirement plan after one has already contributed elective deferrals up to the 402(g) elective deferral limit ($18,000 in 2016, $24,000 if age 50 or older).
The additional after-tax deferrals could be made up to the 415 limit ($53,000 in 2016) less employer contributions made on behalf of the employee. For example, if an employee younger than age 50 received $10,000 in employer contributions in 2016, he/she could make pre-tax deferrals up to the 402(g) limit $18,000, but could also make after-tax contributions (if his/her retirement plan permits) up to an additional $25,000 ($53,000-$18,000-$10,000=$25,000).
As the strategy plays out, if such after-tax contributions are made on an annual basis, a large amount of after-tax contributions would be built up in the retirement plan at retirement age. At that point, the funds could be rolled over to an IRA, with any pre-tax amounts (including all account earnings) rolled to a traditional IRA and after-tax contributions rolled over to a Roth IRA, where taxes would not be due on any distributions from that IRA due to the Roth rules.
As referenced in a PLANSPONSOR article, an Internal Revenue Service (IRS) notice issued in 2014—Notice 2014-54—clarified that this is a strategy that is compliant with the Code (though it is important to note that the rollover of ONLY the after-tax contributions is NOT permitted).NEXT: Hurdles to using the strategy
But does the strategy “work?” Well, that depends on the individual specific situation and is a matter for the individual’s tax adviser to determine. But there are many hurdles to using this strategy in actual practice, as follows:
1) After–tax contributions are not permitted in many plans—about half of all 401(k) plans permit it, and the vast majority of 403(b) plans do not allow it. Also, the use of the provision in retirement plans has declined in recent years, in favor of the newer Roth 401(k)/403(b) provisions which provide for after-tax contributions that grow tax-free immediately and are not taxed upon withdrawal if certain conditions are met (though such contributions ARE subject to the lower 402(g) limit).
2) As discussed in a prior Ask the Experts column after-tax contributions to most retirement plans (with the exception of governmental and non-electing “steeple” church plans/QCCOs) are subject to the same Average Contribution Percentage (ACP) testing as employer matching contributions. This form of nondiscrimination testing is less likely to pass if individuals who are highly compensated employees (defined in 2016 as those who earned more than $120,000 in 2015) contribute the large amounts contemplated by the strategy. Thus, even if a plan permits after-tax contributions, higher earners may be restricted by such testing from contributing significant amounts.
3) Many employees, even high earners, currently do not contribute the maximum pre-tax amount under 402(g), so contributing even greater amounts does not seem to be a likely occurrence.
4) If the individual already receives a large employer contribution to the plan in question (or any other plan that would be subject to the same 415 limit) that contribution will greatly impact the individual’s ability to make after-tax contributions over and above the elective deferral limit.
For all of these reasons, participant after-tax contributions to a retirement plan, even when permitted under the plan, are fairly rare.
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