Pretax Versus Roth Deferrals: Understanding Your 401(k) Contribution Options
By Lisa Haberman, MBA, MAM, ChFC, CLU
A 401(k) is one of the most common qualified retirement plans offered by employers to help their employees save for their retirement. While many employees take advantage of this important benefit, many may not understand that they have a choice in the type of contribution they make—and the mechanics of how their contribution is taxed.
What contribution options do employees have?
Generally, a 401(k) plan permits employees to defer a percentage of their salary or wages into the plan each pay period, usually through a payroll deduction process. Employees may have the option to direct their pay into the plan as pretax contributions or—if the plan permits—as designated Roth contributions. The choice to make pretax deferrals or designated Roth contributions will depend largely on whether the employee prefers to make contributions on a pretax or after-tax basis.
Pretax Deferrals
Historically, employees have leaned toward making pretax deferrals. Not only has this type of contribution been available for many years, but it also provides an immediate tax benefit. Because pretax deferrals are contributed to the qualified plan before taxes are paid, they are not subject to federal income tax withholding during each pay period. But while pretax deferrals are not included as taxable income when contributed to a qualified plan, they are included in wages subject to Social Security (FICA), Medicare, and federal unemployment taxes (FUTA).
Pretax deferrals are reported in Box 12 on the employee’s W-2, Wage and Tax Statement, but they do not appear in Box 1, Wages, tips, other compensation. This means that the pretax deferrals will not be included in taxable income on the employee’s tax return in the year they were contributed, but they will be taxed when withdrawn from the qualified plan—typically after normal retirement age or when the employee has reached the required beginning date for required minimum distributions.
Designated Roth Contributions
Employers have been able to permit employee contributions of after tax dollars to designated Roth accounts since 2006. Unlike pretax deferrals, designated Roth contributions are included in the employee’s annual income and taxed accordingly. The upside for employees is that any earnings on designated Roth contributions will continue to grow tax deferred, and they are tax free if the employee takes a qualified distribution.
A qualified distribution means that the distribution occurs at least five years after the first day of the year of the employee’s first designated Roth contribution. In addition, a distribution is qualified only if it is made
on or after the employee attains age 59½,
on account of the employee’s disability, or
after the employee’s death.
The plan must separately account for designated Roth contributions as well as for any gains or losses incurred on these contributions.
Can employees make pretax deferrals and designated Roth contributions in the same plan year?
Yes, an employee can contribute to both a pretax and a designated Roth account as long as the plan document allows for both types of contributions. The employee may allocate their contributions in any proportion they choose up to the annual deferral limit of $20,500 (2022).
What about catch-up contributions?
Employees who are age 50 or older at the end of the calendar year may contribute an additional $6,500 in 2022. As with “regular” employee deferrals, they can allocate this catch-up contribution however they like between their pretax and designated Roth account.
What type of contribution will employers match?
If the qualified plan document permits, an employer may decide to make an additional matching contribution to those employees who choose to make deferral contributions. For example, the employer may match 50 cents for each dollar that an employee contributes. A plan document may also allow the employer to choose whether to match pretax deferrals, designated Roth contributions, or both.
Employees should carefully weigh their decision about what type of contributions they make because there are many variables to consider. Some prefer the immediate tax deduction that pretax deferrals give, while others favor the possibility of long-term tax-free growth that designated Roth contributions provide. But whatever combination of pretax or Roth deferrals is chosen, these employee contributions can significantly enhance retirement savings.
