In-Plan Roth Rollovers and After-Tax Contributions: Maximizing Deferrals with Limited Future Tax Liability

by Proskauer - Employee Benefits & Executive Compensation Blog
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Plan sponsors seeking to provide employees with the ability to make after-tax contributions to a 401(k) plan may be interested in adding, along with the common Roth contribution feature, non-Roth after-tax contribution and “in-plan Roth rollover” features to their 401(k) plans. These additional features would allow plan participants to save up to $53,000 (for 2015 and as reduced by matching and other employer contributions) annually with limited future tax liability.

By way of background, 401(k) plans may permit two types of after-tax contribution options – Roth contributions and non-Roth after-tax contributions. Roth contributions are advantageous because although the contributions are made on an after-tax basis, neither the contributions themselves nor any earnings accrued on the contributions are taxable when distributed (subject to early withdrawal penalties). However, Roth contributions are limited by an annual deferral limitation of $18,000 (for 2015). Non-Roth after-tax contributions are similarly nontaxable at distribution, but any earnings accrued on the contributions are taxable at distribution. In 2010, the Small Business Jobs Act, as later amended by the American Taxpayer Relief Act of 2012, created “in-plan Roth rollovers,” which allow participants to convert their non-Roth account balance (including pre-tax elective deferrals, matching contributions and after-tax contributions) such that Roth characterization applies thereafter (i.e., no tax on future earnings). Any taxable portion of the converted amount (such as pre-tax elective deferrals and matching contributions, or earnings attributable to non-Roth after-tax contributions) will be subject to income tax in the year of conversion. An in-plan Roth rollover, however, will not trigger an early distribution penalty (provided the amount converted remains in the plan for at least five years).

If a plan design includes these three features, participants could maximize deferrals while limiting future tax exposure by following these three steps:

  1. Elect to defer wages as Roth contributions up to the $18,000 (for 2015) annual deferral limitation.
  2. Elect to defer wages in excess of the $18,000 (for 2015) annual limitation as non-Roth after-tax contributions up to the $53,000 (for 2015 and as reduced by matching and other employer contributions) annual limitation on contributions to defined contribution plans.
  3. Convert the non-Roth after-tax contributions via an in-plan Roth rollover shortly after the contributions are made.

The conversion of the non-Roth after-tax contributions may result in some immediate tax liability if earnings have accrued since the date of contribution. However, after the in-plan Roth rollover, any future earnings will not be taxable at distribution.

Prior to adding these features to a 401(k) plan, plan sponsors should consider the following:

  • Frequency of In-Plan Roth Rollovers. Allowing in-plan Roth rollovers on a frequent basis (for example, after each contribution date) would minimize participants’ future tax liability because there would no taxable earnings on the conversion. However, frequent conversions could be administratively burdensome. Plan sponsors, therefore, may want to limit the number of in-plan Roth rollovers to one or two per year.
  • ACP Testing. Non-Roth after-tax contributions are included for purposes of average contribution percentage (ACP) testing. Because those participants who are willing to contribute in excess of the $18,000 (for 2015) annual deferral limitation are more likely to fall within the “highly compensated employee” group, plan administrators should periodically check for ACP testing issues. To reduce the risk of an ACP test failures, plan sponsors could limit the annual amount of non-Roth after-tax contributions.
  • Rollover Notices. IRS guidance related to in-plan Roth rollovers states that no rollover notice is required when the amount converted to Roth is not otherwise distributable (for example, pre-tax contributions or employer matching contributions). Because non-Roth after-tax contributions can be distributed at any time, it would appear that a rollover notice must be issued each time these contributions are converted in an in-plan Roth rollover.
  • Participant Education. It is important for plan sponsors to ensure that participants obtain adequate guidance on the impact of non-Roth after-tax contributions and in-plan Roth rollovers. For example, by converting non-Roth after-tax contributions to Roth, the contributions are no longer freely distributable.  Instead, once converted, the contributions may only be distributed without penalty upon permitted events (e.g., separation from service, age 59 ½, death, etc.). Additionally, if a participant also wishes to convert their pre-tax account balance in an in-plan Roth rollover, he or she should be aware of the potential for significant tax liability in the year of conversion.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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