Top-Heavy Safe Harbor Plans
Be prepared—after-tax contributions subject a safe harbor 401(k) plan to ACP testing, as well as top-heavy requirements.
Welcome to the Retirement Learning Center’s (RLC’s) Case of the Week. Our ERISA consultants regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans, and other types of retirement savings and income plans, including nonqualified plans, stock options, Social Security and Medicare. This is where we highlight the most relevant topics affecting your business. A recent call with a financial advisor in New York is representative of a common question on 401(k) after-tax contributions.
"If a safe harbor 401(k) plan permits after-tax contributions, can it still be exempt from the top-heavy requirements?"
Highlights of the discussion
Unfortunately, the exemption for safe harbor 401(k) plans related to top-heavy testing is nullified when after-tax contributions are present. In such cases, the safe harbor plan must satisfy top-heavy requirements. However, the plan can take safe harbor nonelective and matching contributions into account in determining whether an employer has satisfied its top-heavy minimum-contribution obligation [IRC §416(c)(2)(A)].
The top-heavy rules require a plan sponsor to make certain minimum contributions to participants and satisfy special vesting rules if a plan is deemed to be top-heavy (i.e., where key employees hold more than 60 percent of the plan’s assets) [IRC §416(a)]. One advantage of safe harbor plans is that they can qualify for an exemption from the top-heavy (as well as other nondiscrimination) requirements.
IRC §416(g)(4)(H) provides an exemption from the top-heavy requirements for certain safe harbor plans. To qualify, the plan “must consist solely of” 1) a cash or deferred arrangement, and 2) basic safe harbor employer contributions (matching or nonelective).
Treas. Regs. 1.401(k)-1(a)(2)(ii) states that a cash or deferred arrangement does not include after-tax employee contributions. A safe harbor plan that permits after-tax contributions would not consist solely of a cash or deferred arrangement and minimum safe harbor employer contributions, and, therefore, would not qualify for the top-heavy exemption. The IRS has provided guidance on other circumstances where a safe harbor plan will not qualify for the top-heavy exemption in Revenue Ruling 2004-13, which is discussed here.
Voluntary, non-Roth, after-tax contributions have gained popularity as a 401(k) plan feature, in part, because they can facilitate tax-efficient Roth conversions a la the " back-door Roth” strategy. However, permitting after-tax contributions in a safe harbor 401(k) plan subjects them to the actual contribution percentage (ACP) test as well as top-heavy requirements.
Conclusion
While after-tax contributions have grown in popularity as a 401(k) plan feature, plan sponsors should be aware of the potential consequences of permitting after-tax contributions in their plans, especially safe harbor plans.
