Frequently, mainstream media will present retirement plan topics offering exciting plan design alternatives that suggest additional contribution limits, creative investment options or other flashy ideas for plan sponsors to consider. In almost all cases, the scope of application of these “hot topics” is very limited.
One such example includes the option for plans to offer traditional after-tax contributions. (Note: this is different than current Roth after-tax contributions present in most retirement plans.) A recent newspaper article glorified the “mega backdoor Roth conversion” but failed to provide details on the limited occurrences in which this passes compliance testing.
A mega backdoor Roth is a special type of 401(k) rollover strategy used by people with high incomes to deposit funds in a Roth individual retirement account (IRA). The after-tax employee contributions work well in highly-compensated employee only plans or Solo(k) one-person plans. The concern is that participants with the ability to take advantage and be most interested in making additional large after-tax contributions would be the highly compensated employees. (A plan participant is considered a highly-compensated employee (HCE) when they are a more than 5% owner OR have compensation in the prior year that exceeds a limit. For the 2021 plan year, an employee who earns more than $130,000 in 2020 is an HCE for 2021. This amount is indexed annually by the IRS.)
The after-tax contributions are tested in the Actual Contribution Percentage Test – ACP, even if a plan has Safe Harbor status. While it isn’t a given the tests will fail, it is very likely and therefore won’t benefit the HCE to contribute after-tax funds if they can’t be retained in the plan.
With the narrow scope of application for this feature, it is important to review this plan design option with your Pension Inc. administrative team and personal tax professionals.