Ever hear of voluntary 401(k) contributions? If you are like most people, probably not. They are after-tax employee contributions like Roth deferrals, but subject to different ERISA rules. Voluntary contributions have been around decades longer than Roth deferrals, but are less popular – mostly because their earnings can’t be withdrawn tax-free at retirement like Roth deferrals.
This disadvantage was partially mitigated when the IRS released Notice 2014–54, which simplified the rules for splitting the pre-tax and after-tax portions of a 401(k) distribution. This guidance made it easier for 401(k) participants to roll voluntary contributions into a Roth IRA, where the money could then grow tax-free – just like Roth deferrals inside a 401(k) plan.
The new IRS guidance got a lot of people excited about making voluntary contributions to their 401(k) plan. Why? They are subject to a much higher annual contribution limit than Roth deferrals ($61,000 vs. $20,500 for 2022). By utilizing this higher limit, a retirement saver can pump additional after-tax contributions into their 401(k) plan and then roll them into a Roth IRA for tax-free growth.
Over the past year, this tax saving strategy received a good bit of coverage in the media - including the New York Times and Morningstar. However, most of the coverage has just focused on the awesomeness of making $58,000 in after-tax contributions and then growing them tax-free inside a Roth IRA. The limited applicability of the strategy was rarely explained. I would like to do that now.
The MEGA “back door” Roth IRA contribution!
Roth IRAs are subject to relatively low contribution limits, based on the income of the taxpayer. Rollovers from a 401(k) plan into a Roth IRA are a different story – they have no dollar or income restrictions. As such, these rollovers are often called a “back door” Roth IRA contribution.
Given the very high contribution limits attributable to voluntary contributions, their rollover has been coined a “mega back door” Roth IRA contribution.
A fit for your 401(k) plan? Probably not.
When the “mega back door” Roth IRA contribution started to receive media coverage, we began to hear from 401(k) sponsors interested in adding voluntary contributions to their plan. The problem? Voluntary contributions are rarely viable in 401(k) plans that benefit both Highly Compensated Employees (HCEs) and non-Highly Compensated Employees (non-HCEs). Why? The Average Contribution Percentage (ACP) test.
The ACP test compares the average contribution rate for plan HCEs to the non-HCE average. This test fails when the HCE average exceeds the non-HCE average by more than the legal limit. In a traditional (non-safe harbor) 401(k) plan, both employer matching and voluntary contributions are tested. In a safe harbor 401(k) plan, just voluntary contributions are (usually) tested.
Why are voluntary contributions a problem? Assuming a HCE makes a $58,000 voluntary contribution to their 401(k) plan, their minimum contribution rate (based on the $265,000 income cap applicable to the ACP test) would be 20%. A high contribution rate like that drags the HCE average upwards making the ACP test more difficult (if not impossible) to pass.
When the ACP test fails, the most common correction method is returning excess contributions to the HCEs that contributed the most until the HCE average drops enough to pass the test. In other words, the HCE that made the $58,000 voluntary contribution is probably going to get a big chunk of that money back in order to pass the ACP test.
Another problem - safe harbor 401(k) plans lose their top heavy test “free pass” when voluntary contributions are made. That could make additional top heavy minimum contributions to “non-key” employees necessary.
Bottom line, voluntary contributions are rarely worth the trouble when a 401(k) plan covers non-HCEs due to their impact to annual IRS testing.
Solo 401(k) plans are the best candidates
Owner-only (or “solo”) 401(k) plans are generally the best candidates for voluntary contributions. Why? With no common law employees, they automatically pass ACP and top heavy testing.
Look, I get it – the “mega back door” Roth IRA contribution is a pretty exciting strategy for those that can afford it. I mean, who doesn’t want the biggest possible tax-free nest egg at retirement? Unfortunately, most 401k plans can’t support the voluntary contributions necessary to make the strategy work.