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Lately, many highly-paid employees have been asking the managers of their corporate benefits programs if they can establish a plan that would allow them to save after-tax dollars into their 401(k) retirement saving plan.
The surge in this heretofore esoteric request is being traced back to a recent Wall Street Journal article headlined “Four Hacks to Boost Your Retirement Savings in 2018.” Among those four suggestions were “Do a ‘mega-backdoor’ Roth IRA conversion.”
The idea was to help employees contribute more to their retirement accounts by converting larger sums to a Roth IRA while minimizing the tax consequences. That agenda may be popular with individual financial advisers but doesn’t always dovetail with the goals of companies who sponsor retirement plans.
First, let me explain that “backdoor” strategy. The idea is that after an employee makes the maximum pretax contribution to a traditional 401(k) or Roth 401(k) — $18,500, or $24,500 for people 50 or older — the employee then asks their employer if their plan allows them to make after-tax contributions.
The Internal Revenue Code permits employees to make contributions totaling $55,000 a year ($61,000 for people 50 or older.) That total can be made up of a combination of pretax or Roth employee contributions, employer contributions, and after-tax employee contributions.
So, if an individual contributes $18,500 and the employer matches up to $11,000, for a total of $29,500, the employee could potentially contribute another $25,500 in after-tax money. Then, the strategy goes, once employees are 59½ or older (or when they leave the firm) they can convert their 401(k) into a traditional IRA, while converting the after-tax portion to a Roth IRA.
This “backdoor” strategy is helped by IRS Notice 2014-54, which clarified rollover rules for allocating pre-tax and post-tax amounts when a distribution sends funds to multiple locations. However, like many investment ideas, while it is technically allowable in theory, for most companies who sponsor retirement plans, it makes less practical sense.
The biggest problem with this saving strategy is that it’s likely to fall afoul of discrimination rules at the level of the company. For starters, according to Vanguard, only 12% of Americans make the maximum contribution annually to their retirement account. So, on average, only one worker in eight might reasonably be expected to even be in a position to use any after-tax savings option.
Making matters worse, most of those employees will be what regulators call highly compensated employees, or HCEs. Under Internal Revenue Code rules, firms must run annual antidiscrimination tests to make sure that 401(k) plans don’t favor HCEs at the expense of other workers. Internal Revenue Code rules classify an employee as an HCE if they have a 5% ownership in the firm, earn $120,000 or more, or, if the plan elects, are in the company’s top 20% of highest earners.
To prove that an after-tax plan is nondiscriminatory, it must pass an Actual Contribution Percentage (ACP) test — something that costs money and could carry a significant administrative burden to complete annually. At its most basic, an ACP test must show that the average 401(k) contributions of HCEs does not exceed contributions made by regular staff by greater than 2%.
Even if the plan passes that ACP test, a plan sponsor will likely add up the costs of administering the change to allow after-tax contributions, the cost and administrative burden of running annual ACP tests and weigh those costs against the potential benefits.
For most companies, that can be a tough comparison, given the relatively small cohort of plan participants who are likely to benefit. After balancing costs against benefits, many companies may decide that this particular “backdoor” should remain firmly shut.
Consider, for illustrative purposes, an executive earning $275,000 who has maxed out his $18,500 (matched dollar-for-dollar) contribution. He now wants to make an additional after-tax contribution of $18,000. Under ACP rules, depending on the test results, it is possible that executive could only make an additional after-tax contribution of 2%, or $5,500.
So, the reality is that for most executives, the actual amount they could contribute to such plans is so modest and the resulting tax benefits so small, that spending the time and effort to establish this additional plan benefit may be unwise for most companies.
Firms with additional budget for new employee benefits might instead consider using those resources to bolster financial planning and educational services that will benefit the largest number of plan participants.
Michael Krucker is a senior consulting manager with Plante Moran’s Employee Benefits Consulting practice.