Ask the Experts – Turning After-Tax Account to Emergency Savings in 403(b) Plans

“We sponsor an ERISA 403(b) plan that has historically allowed for after-tax contributions, but that feature has been largely dormant. However, I read a recent PLANSPONSOR article about how a 401(k) plan sponsor was able to successfully utilize its after-tax source as an emergency savings account within the retirement plan. Can this be done in a 403(b) plan as well? If so, are there any drawbacks to this solution? We have been investigating automated emergency savings account options as part of a strategy to promote the overall financial wellness of our employees?”

Stacey Bradford, Kimberly Boberg, David Levine and David Powell, with Groom Law Group, and Michael A. Webb, vice president, Retirement Plan Services, Cammack Retirement Group, answer:

Thank you for your question! It is indeed possible for a 403(b) plan’s after-tax contribution source to be designed as an in-plan emergency savings account, though you should consult with your retirement plan counsel to determine whether such a design would work in your particular plan. Note that contributions to such an after-tax emergency savings account, would NOT be subject to the 402(g) limit on elective deferrals, so these contributions could be made in addition to such deferrals.

However, as we discussed in our Ask the Experts column on after-tax rollover strategies, there are some potential hurdles to the effectiveness of this approach, as follows:

1)         After-tax contributions to most retirement plans (with the exception of governmental and non-electing “steeple” church plans/QCCOs) are subject to the same actual contribution percentage (ACP) testing as employer matching contributions. This form of nondiscrimination testing is less likely to pass if individuals who are highly compensated employees (defined in 2020 as those who earned more than $125,000 in 2019) contribute large after-tax amounts, which are permitted since after-tax contributions are not constrained by the 402(g) elective deferral limit (but see item 2) on the 415 limit, below). Thus, even if a plan permits after-tax contributions for an emergency savings fund or other purposes, higher earners may be restricted by such testing from contributing significant amounts.

2)         If a participant already receives a large employer contribution to the plan in question (or any other plan that would be subject to the same 415 limit) that contribution could impact the participant’s ability to make after-tax contributions.

3)         Though a plan may be designed to permit withdrawals of after-tax contributions, earnings on such contributions would be subject to taxation when withdrawn, as well as a 10% penalty if the participant is younger than 59 ½, (note that there are exceptions to the penalty; for example, if a participant terminates employment on or after the calendar year in which he/she turns age 55).

NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.