Participant Contribution Types
There are different ways that participants can contribute from their compensation to their workplace retirement plan. Participants and employers need to understand the differences since your plan may not allow all of these contribution types, and different rules apply to each one. This article breaks down the key points.
It is important to note that a Roth 401(k) or 403(b), are not Roth IRAs. Occasionally we receive feedback from employees that expose some confusion around this. Look for other articles coming soon that will go into more detail. For now, know that IRA stands for Individual Retirement Account, whether it is Traditional or Roth. The 2022 annual contribution limits are lower for IRAs, $6,000 per person (or $7,000 for persons age 50 and older) than they are for company-sponsored retirement plans such as a 401(k) (see limits below).
These contribution limits will increase in 2023 to $6,500 per person (or $7,500 for persons age 50 and older).
You may have an IRA on your own; however, you can have a 401(k) or 403(b) through your employer. In some circumstances, you are allowed to contribute to both an IRA and a company-sponsored retirement plan, such as a 401(k). However, higher incomes may limit IRA contribution limits. Please consult with a tax professional.
Pre-tax Contributions vs. Roth Contributions
These contribution types are most commonly associated with a 401(k) or other retirement plans and are sometimes referred to as a “salary deferral.” Plan participants can deposit a portion of their compensation into their plan on a pre-tax basis, reducing taxable income. However, the contribution with all earnings is subject to taxation when it is withdrawn. If a plan permits Roth contributions, participants can deposit post-tax dollars into the plan. When the participant withdraws the funds during retirement, the withdrawal is tax-free as long as the Roth account was opened and first contributed to five or more years before the withdrawal.
There aren't many major differences between Roth and pre-tax 401(k) contributions other than the tax treatment. Some participants prefer Roth contributions because future withdrawals are tax-free, including earnings, interest, dividends, and capital gains. However, both types allow withdrawals at age 59½ and older without an early withdrawal penalty, and they are subject to Required Minimum Distribution (“RMD”) rules when participants reach age 72.
In the example below, you can see the principal of a $200 monthly contribution, growing over 10, 20, 30, and 40 years at a hypothetical growth rate of 7%. As you can see, if over 40 years the participant contributes $96,000, it could grow to $528,025. Ask yourself, which would you rather pay taxes on, $96,000 or $528,025? Essentially, with a Roth contribution, you only pay taxes on the amount you contributed, in this case, $96,000, and with a Pre-tax contribution, you will pay taxes on the entire $528,025. Even if you are in a lower tax bracket in retirement, you may end up paying more in total tax. The preferred option may depend on your tax bracket, so it’s best to consult with an advisor to determine how best to allocate your contributions.
If your plan supports both contribution types, a participant’s contributions limits to pre-tax and Roth are combined for purposes of applying the annual contribution limits for 2022 are $20,500, or $27,000 for persons age 50 and older. These limits will increase in 2023 to $22,500, or $30,000 for persons age 50 and older. If a participant has selected both pre-tax and Roth contributions and is eligible for employer matching, the employer will match accordingly.
Roth and After-Tax contributions to a workplace retirement plan are not the same things, and they have some key differences. As mentioned above, Roth contributions are subject to the annual participant contribution limits. In contrast, after-tax contributions are not considered under the tax code to be a “deferral” and therefore are not subject to those limits. In other words, after-tax contributions to a retirement plan can be more than the $20,500 annual limit (plus the additional $6,500 catch-up amount for participants over age 50) as long as the participant’s and employer’s total contributions do not exceed $61,000 as of the year 2022.
On the other hand in 2023, the after-tax contributions to a retirement plan can be more than the $22,500 annual limit (plus the additional $7,500 catch-up amount for participants over age 50) as long as the participant's employer's total contributions do not exceed $66,000.
Additionally, the tax treatment of Roth and after-tax contributions differ at withdrawal. Any earnings on Roth contributions are tax-free, but earnings on after-tax contributions are taxed as ordinary income. The tax code also requires withdrawals of after-tax contributions to also include a withdrawal of any earnings associated with those contributions. That said, if Roth or After-Tax dollars are rolled into a Roth IRA that was established at least five years before the first withdrawal occurs, both the Roth and After-tax dollars in the Roth IRA will take on the rules of the Roth IRA and not be subject to taxes, penalties or age 72 RMDs, as long as both the Roth IRA and 401(k) account(s) was established more than five years prior to the first withdrawal, and the account holder is age 59 ½ or older.
At the time of this writing (August 2021), Vestwell does not support after-tax contributions.