FIS Relius
IRS Releases Guidance on After-tax Rollovers - Part 3: After-tax Sources and Testing 12/4/2014
Email This Link

Two months ago, the IRS released important guidance, Notice 2014-54, on the treatment of after-tax money distributed or rolled over from retirement plans.  The guidance has ignited a firestorm of interest in using after-tax contributions, particularly in owner-only plans.

 

This is the third of four technical updates dealing with after-tax contributions.  The first focused on key principles affecting after-tax distributions, which have not changed.  The second focused on the changes the IRS made in Notice 2014-54.  This update addresses sources and testing of after-tax funds.  The final update looks at using after-tax contributions to bring owners to the 415 limit. 

 

Sources

 

There are several possible transactions which can give rise to after-tax funds (or basis) in a retirement plan.  These are some of the most common:

 

After-tax voluntary employee contributions – The recent IRS compliance survey of 1200 401(k) plans suggests that roughly 4% of 401(k) plans accept after-tax voluntary contributions.  Anecdotal evidence suggests that estimate is high. But in the days before elective deferral plans became prevalent, after-tax employee contributions were somewhat more commonplace.  Ideally, a plan separately accounts for the employee contribution account, in order to provide favorable tax treatment for distributions. The employee contributions are after-tax, but are not Roth contributions, and therefore the earnings on those contributions are pretax. Some plans match after-tax voluntary employee contributions for many of the same reasons plans match elective deferrals.

 

Designated Roth account – The designated Roth account includes the following contribution sources:  Roth deferrals, rollovers from other Roth plans, and in-plan Roth rollovers. These funds are always after-tax.  Earnings from these sources are also part of the designated Roth account.  If a plan makes a qualified distribution from the designated Roth account, the entire distribution is after-tax.  If a plan makes a nonqualified distribution from a designated Roth account, the earnings are pretax.

 

Repaid deemed distributions – If a participant repays a participant loan that had previously been treated as a deemed distribution (so the participant received a 1099-R), the entire amount repaid, principal and interest, is after-tax. 

 

Repaid cash-out distribution – A plan using the cash-out forfeiture rule must permit participants to “buy back” their forfeitures by returning to the plan the funds distributed to them.  If those funds come from the participant (rather than from a rollover), they are after-tax funds.

 

Current cost of life insurance protection – If the plan purchases life insurance covering a participant, the participant pays tax on the current cost of life insurance protection (formerly known as “P.S. 58 costs”). These amounts become after-tax amounts.

 

Testing

 

The coverage regulations require the employer to disaggregate, for purposes of coverage and nondiscrimination testing, contributions tested under Code §401(m). Code §401(m) provides the testing rules for matching contributions and “employee contributions.” The phrase “employee contributions” refers to after-tax voluntary employee contributions described above, but does not refer to other after-tax sources, such as Roth deferrals and repaid participant loans. The Actual Contribution Percentage (ACP) test considers matching contributions and employee contributions together. 

 

Example 1 – Mary has compensation of $100,000 for 2014.  She deferred $8,000 and was allocated a $4,000 match.  In addition, she made a $2,000 after-tax voluntary employee contribution.  The total amount tested under the ACP test is $6,000 and Mary’s Actual Contribution Ratio (ACR) is 6%.

 

For purposes of the coverage test, a participant benefits from employee contributions if the participant is eligible to make employee contributions, regardless of whether the participant chooses to make the contributions. This is similar to the way the coverage test treats elective deferrals. 

 

The coverage test treats a participant as benefiting with respect to matching contributions if the participant would be eligible to receive a match (i.e., if the participant satisfies the allocation conditions to receive the match).  Of course, the participant must actually defer (or, in some plans, make an employee contribution) to receive a match, but that is not part of the coverage test.  The coverage test looks only at whether the participant would have been allocated a match had the participant contributed.

 

Putting these two rules together, a participant is an “eligible employee,” benefiting from the 401(m) portion of the plan for purposes of coverage, and counted in the ACP test, if the employee either (1) is eligible to make an employee contribution, or (2) satisfies the allocation conditions to receive a match. If all participants are eligible to make employee contributions, then all participants are benefiting from the 401(m) portion of the plan regardless of whether they are eligible to receive a matching contribution.

 

Example 2 – Plan X is a 401(k) plan which each plan year provides a match of 50% of elective deferrals not exceeding 6% of compensation to all participants who have at least 1,000 hours of service for the year.  The plan does not allow employee contributions but all employees are eligible to make elective deferrals. The chart below shows all plan participants.  Doug is not benefiting from the 401(m) portion of the plan because Doug does not satisfy the allocation condition to receive a match. The 401(m) portion of the plan fails the ratio percentage test for coverage because it covers only 2/3 of the NHCEs.  However, the plan does pass the average benefit test.  For purposes of the ACP test, the plan compares the ACR for Ann against the average of the ACRs for Bart and Carmen. The plan disregards Doug in the ACP test because he was not eligible to receive a match, regardless of whether he deferred.  In this case, the ACP for both the HCE and the NHCEs is 3%.

 

Participant

HCE?

1000 HOS?

Comp

Defer

Match

Ann

Yes

Yes

$ 250,000

$ 16,000

$ 7,500

Bart

No

Yes

$ 100,000

$ 10,000

$ 3,000

Carmen

No

Yes

$ 60,000

$ 3,600

$ 1,800

Doug

No

No

$ 20,000

$ 0

$ 0

 

Example 3 – Assume the same facts as Example 2, except that all participants can make an employee (after-tax) contribution, as well as an elective deferral.  All participants, including Doug, benefit from the 401(m) portion of the plan because all are eligible make employee contributions.  Therefore, the 401(m) portion of the plan satisfies the ratio percentage test for coverage. The plan counts all participants, including Doug, in the ACP test, which looks at the sum of matching contributions and after-tax contributions.  Ann’s ACR is 5% ($12,500/$250,000).  Bart and Carmen each have an ACR of 3%, and Doug’s ACR is 0%.  The NHCE ACP is 2% and the HCE ACP is 5%.  The plan fails the ACP test.

 

Participant

HCE?

1000 HOS?

Comp

Defer

Match

After-tax

Ann

Yes

Yes

$ 250,000

$ 16,000

$ 7,500

$5,000

Bart

No

Yes

$ 100,000

$ 10,000

$ 3,000

$ 0

Carmen

No

Yes

$ 60,000

$ 3,600

$ 1,800

$ 0

Doug

No

No

$ 20,000

$ 0

$ 0

$ 0

 

Some plans match employee contributions. These matching contributions are still employer contributions counted in the ACP test with other matching contributions.

 

Note if the plan had needed to perform the average benefits test, either for coverage or for the general nondiscrimination test, that employee contributions are not included in the average benefit percentage test. In Example 3, Ann’s average benefit percentage is ($16,000 + $7,500)/$250,000, or 9.4%.

 

As a practical matter, current-year tested plans that pass the ADP test almost always pass the ACP test if the plan does not permit employee contributions. But as the examples above show, the addition of employee contributions to the mix can cause the plan to fail the ACP test.  One strategy to help pass the ACP test is to “shift” elective deferrals from the ADP test to the ACP test.  The plan must satisfy the ADP test with and without the shifted deferrals. In addition, the plan must use the same testing method (current year or prior year) for both the ADP and ACP tests, and must perform both the ADP and ACP tests (i.e., the rule is unavailable to ADP safe harbor plans and to 403(b) plans).

 

Example 4 – Continuing Example 3, suppose the plan shifts $1,680 of Carmen’s elective deferrals from the ADP test to the ACP test.  Before making the shift, the plan passed the ADP test with flying colors, with an HCE ADP of 6.4% and an NHCE ADP of 5.33% (remembering to count Doug). After the shift, the plan barely passes the ADP test, with an NHCE ADP of 4.4%.  While the ACP test still fails, it is much closer, with an NHCE ACP of 2.93% (as compared to 2.0% before the shift)

 

Participant

HCE?

1000 HOS?

Comp

Adjusted Defer

Adjusted Match

After-tax

Ann

Yes

Yes

$ 250,000

$ 16,000

$ 7,500

$5,000

Bart

No

Yes

$ 100,000

$ 10,000

$ 3,000

$ 0

Carmen

No

Yes

$ 60,000

$ 1,920

$ 3,480

$ 0

Doug

No

No

$ 20,000

$ 0

$ 0

$ 0

 

There are three other ways to deal with a failed ACP test: (1) return excess aggregate contributions to the HCEs, (2) make a Qualified Nonelective Contribution (QNEC) for the NHCEs, or (3) make an additional matching contribution for the NHCEs. Anti-targeting rules apply to both options (2) and (3). These rules restrict the ability to make contributions to the lowest paid individuals in order to boost their percentages with a small employer contribution.

 

Example 5 – After shifting the deferrals, the plan can easily address the remaining ACP failure by returning $167 of after-tax contributions (plus earnings) to Ann.  That will lower her ACR to 4.93%. Ann is not taxed on the return of the after-tax contributions (because she did not deduct them when she contributed to the plan).  However, she is taxed on the earnings.

 

Example 6 – Assume the plan is top-heavy and Doug must receive a $600 top-heavy minimum contribution. The employer can repair the failed ACP test by contributing $40 of the $600 as a QNEC (fully vested), and counting the QNEC in the ACP test.  Since the amount of the QNEC (0.2% of Doug’s compensation) is less than 5% of compensation, it satisfies the anti-targeting rules.

 

Example 7 – Assume the plan allows the employer to make discretionary matching contributions to one or more NHCEs. The employer allocates Carmen an additional $120 match.  That will bring the NHCE ACP up to 4.4% and the plan passes the ACP test.  Carmen’s total match is still less than her elective deferrals and less than 5% of her compensation, so the match satisfies the anti-targeting rules.

 

Generally, an alternative approach to the ACP test is use of the ACP safe harbor rules.  Unfortunately, the ACP test safe harbor does not apply to employee contributions.  If a plan has employee contributions, then the plan must pass the ACP test even if the plan otherwise satisfies the ACP safe harbor with respect to matching contributions.  In performing the ACP test, the plan has the choice to count or not count the matching contributions.

 

Example 8 – Continuing Example 3, suppose the plan satisfies the ADP and ACP safe harbor (because the employer makes a 3% safe harbor nonelective contribution for all NHCE participants).  Because the plan includes employee contributions, the plan must nonetheless satisfy the ACP test. The employer can choose between testing the matching contributions and employee contributions together, or can test the employee contributions alone.  Since no NHCE made an employee contribution, Ann would be much better off if the plan included matching contributions in the ACP test. 

 

There is a special rule which provides that if a plan satisfies the ADP test safe harbor by providing a basic match or an enhanced match, but does not qualify for the ACP safe harbor, the plan can disregard matching contributions up to 4% of compensation in performing the ACP test. That optional exclusion does not apply to employee contributions and is not be available for the plan in the foregoing examples.

 

There is another rule which provides that a plan is exempt from the top-heavy rules if the plan only includes contributions that satisfy the ADP and ACP test safe harbor provisions. The exemption is not available if participants make employee contributions to the plan because there is no ACP test safe harbor for employee contributions.

 

We will discuss in details distributions and strategies for after-tax contributions in the upcoming “After-tax Contributions: The Untold Story” Webcast presented on December 17, and at the Advanced Pension Conference in St. Pete Beach, Florida. Read details about these events below.

 

=================================================

 

Advanced Pension Conference – January 28-30 – Register by 12/22 and save $150

Earn up to 19 hours of CE credits. View the program complete Agenda and register online.

 

Just for ERPAs Workshop – January 27 – Register now

This program is held in conjunction with the Advanced Pension Conference in St. Pete Beach, FL. Earn up to 8 hours of ERPA credit, including 2 ethics hours. Pay only $250 for the workshop when you register for both the APC and the ERPA workshop. See the workshop agenda and register online.

 

2015 Live Workshops – Scheduling Now

401(k) Plans: Beyond the Basics (2-day program) - January-February

New Workshops — the two workshops below are presented back-to-back at the same location:

Fixing the Broken Plan (1-day program) - February-March

Effective Plan Design (1-day program) - February-March

Final dates, locations, and program details will be available shortly in December, here:
http://www.relius.net/Events/events.aspx?Seminar

 

Web Seminars

1099-R: An Ongoing Challenge, December 8, 12:00 pm ET

Ethics: New Rules and Old Problems, December 9, 12:00 pm ET

After-tax Contributions: The Untold Story, December 17, 2:00 pm ET

457(b) Plans for 401(k) Practitioners, January 12, 12:00 pm ET

Earned Income - A Practical Approach, January 14, 12:00 pm ET

Defined Benefit Plans for DC Practitioners - 2 parts, January 20-21, 12:00 ET each day

Details and online registration: www.relius.net/Events/events.aspx?Web

 

Archived Web Seminars

“Restatement Perspectives” Web seminar series (12 titles), Fall 2014

PPA Pre-approved Plan Workshop, Corbel Document - 3 parts, July 2014

PPA Pre-approved Plan Workshop, PPD Document - 3 parts, July 2014

ERISA Workshop: Rollover Taxation and Other Developments, October 2014

ERISA: Who Are These Fiduciaries? November 2014

403(b) Plans for 401(k) Practitioners - 3 parts, February 2014

Fee Disclosure Guide, April 2014

Attribution: What You don't Know Can Hurt You, April 2014

New Ways to Avoid Late Filing Penalties, June 2014

For program details about archived Web seminars, and to register:
www.relius.net/events/events.aspx?Archive

 

Ask Us about Private Seminars

  • We come to you – where you want, when you want
  • Save on staff travel and hotel expenses
  • Customize your program – choose only the topics your staff needs
  • Present information to your staff at their knowledge and experience level
  • Ample time for in-depth coverage, as well as questions and answers
  • Piggyback with your own regional, sales, training, or awards meetings
  • Attractive pricing

Book your private seminar today on Restatement or other custom program. For more information, visit our website: http://www.relius.net/Products/seminaronsite.aspx. You may also email us at relius.education@sungard.com.