At a high level summary, VAT contributions allow employees to put additional after-tax (not Roth) contributions into the retirement plan, often in conjunction with Pretax and/or Roth deferrals. The VAT contributions have annual IRS nondiscrimination testing requirements separate from the Roth and Pretax Deferrals, though the testing structure is very similar, whereby the average contribution rate between Owner/Highly Compensated employees (HCE) group vs. the Non-Highly Compensated employees (NHCE) group have to be satisfied each year.
If the plan's NHCE/non-owners group are not using the VAT feature or using it at a very low rate compared to their HCE/Owner counterparts, the VAT contributions made by an Owner/HCEs will likely fail the annual nondiscrimination testing. Lack of overall participation and compliance testing challenges are often why many employers do not add the VAT feature to the corporate retirement plan.
Factors to consider offering the VAT feature are:
- Adoption rate of the VAT feature by NHCEs - modest to balanced adoption by NHCEs can help keep the annual nondiscrimination testing passing.
- Adoption rate of the VAT feature by HCEs - too many HCEs and/or HCEs with lower comp but high participation in VAT (ex. owners) can heavily tip the nondiscrimination testing to fail.
- Company's participation with an employer match - the employer match is not required for a company to also have the VAT feature, however, the annual nondiscrimination testing pools the employer match contributions and VAT contributions for testing purposes. Having an employer match is a key indicator with retirement programs that successfully pass the annual nondiscrimination testing.
When the VAT is not a good fit for the corporate retirement plan:
If the VAT feature is not viable for the company to put in place, companies will often instead encourage employees to (1) ensure they are maxing out their annual 401k contributions (called the "402(g) Deferral Limit") and (2) consider options for the Roth Conversion via any IRA options available to them (their individual "Backdoor Roth"). Note: if employees are not already maxing out the annual 402(g) limit, VAT contributions are not typically suitable because the main benefit of VAT contributions is to exceed the contributions already allowed in the plan's annual 402(g) Deferral limit.
When the VAT can be a better fit for the corporate retirement plan
The VAT Contributions are required to be tested under the annual Actual Percentage Contribution (ACP) test. Retirement plans may find that their employer match (both discretionary or Safe Harbor) can assist with passing the ACP test. Note, with Match Safe Harbor, the match contribution testing and Top Heavy testing still have an automatic pass, but those match contributions are then "repurposed" for the ACP testing - looking at the overall contribution percentages for all participants who have Match and/or VAT contributions for the plan year. Thus, plans utilizing match may find that there is better opportunity to support VAT contributions in the plan, even though VAT contributions are so predominately utilized by HCEs. Further, plans with Match that also have Automatic Enrollment can often fair even better in the annual ACP testing.
However, be cautioned that the Match (and Auto Enroll) recipe is not a perfect solution. The ACP testing will vary from year to year, sometimes significantly - as HCEs using the VAT contributions will do so at different rates (%) from year to year. Ex. if in one year an HCE has lower compensation but makes a very large VAT contribution, their ACP rate may result in a very high testing percentage, causing ACP test failure - leading to a correction refund to the HCEs. Also, the test failure correction is not "one-to-one", meaning in a failed ACP test, one HCE's higher testing percentage may cause testing failure, that then has to be corrected across multiple HCEs using the VAT contribution, not just that one HCE with the high percentage.
Note also that it is largely uncommon for VAT contributions to be eligible for the employer match. This is because testing for the VAT is already prone to being volatile, so increasing HCE benefiting percentage in their match is considered imprudent. The best practice for plans with VAT is to direct participants to first take full advantage of the "standard" deferrals under 402(g), standard meaning Pre-tax and Roth deferrals. Further reminding that Roth Deferrals do not require in-plan conversion, such as how VAT contribution do require Roth conversion. And further noting that the "Roth Clock" on converted VAT contributions "start" with each conversion, so there is also elevated administration for VAT contributions & In-Plan Roth Conversion.
If the company does want to add the VAT feature to the corporate retirement plan:
A plan amendment would be completed to add the feature. Part of the amendment process will include a participant notice to disclose to the employees about the new plan feature.
Operationally, the company's payroll system will need to be wired to manage the annual IRS limits the converge between the 402(g) Deferral limit (for standard Pretax & Roth Deferrals) and the 415 Annual Additions Limit (for VAT Contributions, Employer Match (if appliable), and Employer Profit Sharing (as applicable)).
Please note: in any year were the nondiscrimination testing fails due to the overcontribution of VAT contributions, the VAT participants will have the excess VAT contributions distributed out of the plan and paid back to them via a Pro Rata calculation based on HCE status. And an 1099R tax form will be produced on behalf of any employees receiving refunds. Said another way, a testing failure is handled by the plan, not by payroll.