Participant Contribution Types: Differences between Pre-tax, Roth, and After-tax

Participant Contribution Types

There are different ways that participants can contribute from their compensation to their workplace retirement plan. It’s important for participants and plan sponsors 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. 

Pre-tax Contributions vs. Roth Contributions

These contribution types are most commonly associated with 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, which reduces taxable income now. However, the contribution with all earnings is subject to taxation when it is withdrawn. If a plan permits Roth contributions, participants can deposit after-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.

Other than the tax treatment, there aren't many major differences between Roth and pre-tax 401(k) contributions. 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 without an early withdrawal penalty, and they are subject to Required Minimum Distribution (“RMD”) rules when participants reach age 72. 

If your plan supports both contribution types, a participant’s contributions on a pre-tax and Roth basis are aggregated together for purposes of applying the annual contribution limits. If a participant has selected both pre-tax and Roth contributions and is entitled to an employer match, the employer match will be deposited into the contribution type selected by the Plan Sponsor. The Plan Sponsor is responsible for setting up all plan features in the payroll system, including where any employer match should be deposited for participants who select both a Roth and pre-tax deferral. Please see our Payroll Integrations Help Center for more details about setting up your plan with your payroll provider.

After-Tax Contributions

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, whereas 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 $23,000 annual limit (plus the additional $7,500 catch-up amount for participants over age 50) as long as the participant’s and employer’s total contributions do not exceed $69,000 in 2024.

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 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. Therefore, it is critical that when plan sponsors submit their payroll files (whether directly or indirectly through a payroll provider), be sure that all participants’ Roth contributions are not mistakenly listed as “after-tax contributions.” If they are, your contributions file will be rejected and will not be processed. Please be sure to review the specific formatting and other requirements for your payroll files in the Help Center.