After-Tax 401(k) Contributions Part II: Pitfalls and Interactions with Other Retirement Plans

Be sure to read until the end for a special trivia question!

Sometimes filling unused OR time can backfire. On the bright side, this surgeon’s Press Ganey scores should get a nice boost!

Note: This is the second of a two-part series on After-Tax 401(k) contributions and the “Mega Backdoor Roth.” I recommend also reading Part I, which you can access here.

Synergy with Cash Balance Plans

Cash balance plans can be a wonderful tax planning tool for high-income self-employed physicians.

They are not for everyone. They are more expensive to set up and maintain than a basic solo 401(k), and they generally work best for physicians with strong, predictable cash flow who expect to remain self-employed for several years. But when they fit, they can allow much larger pre-tax retirement contributions than a 401(k) alone.

There is one unwanted side effect. Adding a cash balance plan can potentially reduce the deductible employer contribution limit to a defined contribution plan. In some situations, this can reduce the maximum deductible employer contribution to the 401(k) from 25% of compensation to 6%.

Yuck.

However, this does not necessarily mean the remaining 401(k) space is wasted. A cash balance plan may limit employer contributions to the 401(k), but it does not necessarily prevent after-tax employee contributions to the 401(k), assuming the plan allows them and the overall limits are respected.

This is why the combination can be so powerful. For the right high-income physician, the combination of a cash balance plan and after-tax solo 401(k) contributions can be like combination therapy. Each tool works through a different mechanism. Used together, they can create a much stronger retirement and tax-planning effect than either one alone.

But like combination therapy, the regimen needs to fit the patient.

Pitfall #1: This Is Not a DIY Project

A basic solo 401(k) can be straightforward. A custom solo 401(k) with after-tax contributions, in-plan Roth conversions, in-service rollover features, and possibly a cash balance plan is not straightforward.

Small business retirement plans are not as complicated as brain surgery, but creating a customized plan is not a do-it-yourself project.

You need a plan document. You need an adoption agreement. You need to know what the plan allows. You need to know when contributions must be made. You need to know how conversions are reported. You need to know whether the plan needs Form 5500-EZ. You need to know whether there are controlled group or affiliated service group issues. You need to know whether employees create testing problems.

A Third-Party Administrator, or TPA, specializes in retirement plan administration and compliance. A good TPA is often essential for this type of strategy.

Financial planners and tax advisors vary widely in their expertise with these plans. As a tax advisor, I try to understand these strategies well enough to know when they may benefit clients, when they may create problems, and when an outside specialist needs to be involved.

Pitfall #2: Employees Change Everything

This post is written primarily for solopreneur physicians. A self-employed physician with no eligible employees is often the cleanest candidate for a custom solo 401(k) with after-tax contributions. If you have eligible employees, the analysis changes dramatically.

Plans that allow after-tax employee contributions are subject to nondiscrimination testing. In plain English, the plan generally cannot be designed so that only the owner or highest-paid employees receive the meaningful benefit.

If the physician-owner contributes a large amount after-tax, while employees contribute little or nothing, the plan may fail testing. The result may be refunds, additional employer contributions, or plan design changes. In other words, the strategy may still be possible with employees, but it can become much more expensive.

This is also why physicians who own part of a practice, work through a DSO structure, or have multiple related entities need to be careful. Controlled group and affiliated service group rules can cause employees of related entities to be treated as employees for retirement plan purposes. That can turn what looked like a solo 401(k) into something very different.

Pitfall #3: The 403(b) Trap

Special rules apply if you are also covered by a 403(b) plan at your primary employer. This often surprises physicians.

Most annual additions limits are applied by employer. So if you have a 401(k) at one unrelated employer and a solo 401(k) for your side business, the annual additions limits may be separate, even though the employee deferral limit is shared.

A 403(b) can be different. For 415(c) purposes, a 403(b) contract is generally treated as controlled by the participant. If you also control the business sponsoring your solo 401(k), the 403(b) and solo 401(k) may need to be aggregated for the annual additions limit. That means your hospital 403(b) contributions could sharply reduce how much room you have in your solo 401(k).

This is an easy issue to miss, and it is one of the reasons this calculation should be reviewed before contributions are made.

Pitfall #4: The Money Needs a Roth Exit Ramp

After-tax contributions are only the first step. The second step is getting the money into Roth.

If you set up a custom solo 401(k) specifically for this strategy, the plan should generally allow either in-plan Roth conversions or in-service rollovers to a Roth IRA. But “should” is not good enough. You want to verify the feature in the plan document and adoption agreement before putting money in.

If you work for an employer that allows after-tax 401(k) contributions, check whether the plan also allows in-plan Roth conversions or in-service Roth IRA rollovers. If the answer is no, the after-tax contributions may be stuck in the plan until you separate from service or otherwise become eligible for a distribution. That is not necessarily fatal, but it reduces the benefit.

The longer after-tax contributions remain unconverted, the more taxable growth can accumulate. When the money eventually comes out, the contribution portion may be after-tax, but the earnings are generally taxable unless handled properly. In other words, after-tax contributions without a Roth conversion feature are not the same thing as Roth contributions.

Continuing with the same metaphor of the “unused OR time” from Part I of this series, this is like finding a case to fill the time and then discovering that the patient has complications or a difficult disposition afterward.

TaxSmart Takeaway

After-tax 401(k) contributions become especially interesting when paired with a cash balance plan. A cash balance plan may allow very large pre-tax contributions, while after-tax 401(k) contributions may help prevent unused defined contribution plan space from going to waste. For high-income physicians with the right facts, the combination can be one of the most powerful retirement planning strategies available.

But this is not a plug-and-play strategy. The plan document must be drafted correctly. The adoption agreement must allow the necessary features. The annual additions limit must be calculated properly. The Roth conversion mechanics need to be clear. If there are employees, related entities, a 403(b), or a cash balance plan, the analysis becomes more complicated.

For the right physician, after-tax 401(k) contributions can be a powerful tool. For the wrong setup, they can create an expensive compliance headache. Is that a reason to avoid this strategy altogether? No, but it is a reason to treat it with the respect it deserves.

Special Trivia Question!

This post mentions Form 5500-EZ in passing. It is a form that needs to be filed with the IRS when the balance of a Solo 401(k) exceeds $250,000 (or possibly as soon as a few short years after maximum contributions are made annually).

What is the penalty for not filing Form 5500-EZ?

A. $100 per month, reaching a maximum after four months ($400)
B. $250 per month, no maximum
C. $150 per week, reaching a maximum after 24 weeks ($3,600)
D. $215 per week per plan participant, no maximum
E. $250 per day, up to a maximum of $150,000

Click here for the answer!