You’ve decided to contribute to your employer’s retirement savings plan. Now what? It can be confusing to decide whether to make pretax or post-tax (Roth) contributions. Here are some tips to consider.
Employer-Sponsored Retirement Savings Plans and Employer Contributions
As part of the financial planning work I do with clients, I review a lot of employer-sponsored retirement savings plans. These plans go by an alphabet soup of names, typically based on the IRS codes that established them: 401k, 403b, 457b, SIMPLE IRA.
These plans are all ways that the IRS permits an employee to save for retirement. These plans are not meant for general types of saving; instead, they are specifically for retirement savings and there can be penalties for withdrawing money prior to retirement.
Many employer-sponsored retirement savings plans permit the employer to make a contribution on behalf of their employees. This article doesn’t get into the details around employer contributions. However, as an employee if you aren’t making a contribution to your retirement plan that at least qualifies you to receive the full employer contribution, you may be leaving money on the table. This is one of the first things I look at when examining a client’s employer-sponsored retirement savings plan.
Be sure you know what your employer contribution is, and whether you are receiving it.
Employee Contributions: Pretax or Post-Tax Roth
Retirement savings plans typically offer a choice of contribution types that an employee can make. Here’s a run down of the types of contributions, and some potential scenarios where it may make sense for an employee to make a specific type of contribution.
Many employer-sponsored retirement savings plans permit employees to make a pretax or a post-tax Roth contribution. Basically the decision is a question of when to pay taxes: now, or later.
Pretax Employee Contribution
A pretax employee contribution is withheld from an employee’s paycheck before taxes are paid. The contribution goes into the retirement savings plan “pretax”. This is also called a “tax-deferred” contribution, because you are deferring taxes until you withdraw the money. When the contribution and any earnings are withdrawn in retirement, taxes are owed on 100% of the withdrawals.
Some scenarios where it may make sense to make pretax employee contributions:
- The employee is in in a high tax bracket today and expects they will be in a lower tax bracket in retirement
- The employee is on a very tight budget and can’t afford to withhold much from their paycheck
- The employee has a lot of personal debt (student loans, credit card debt, car payments)
- The employee is on an income-based student loan repayment program that doesn’t include pretax withholdings in the calculation for repayment amounts AND the employee is planning to receive loan forgiveness such as Public Student Loan Forgiveness (PSLF)
Post-tax Roth Employee Contribution
A post-tax Roth employee contribution is withheld from an employee’s paycheck AFTER taxes are paid. The contribution goes into the retirement savings plan “after tax” is paid on the contribution. When the contribution and any earnings are withdrawn in retirement, no taxes are owed on 100% of the withdrawals.
Some scenarios where it may make sense to make post-tax Roth employee contributions:
- The employee is in a low tax bracket today and expects that they will be in a higher tax bracket in the future
- The employee has a long time to go (for example 20+ years) before they retire, so they expect the long-term earnings in their plan to be significant
- The employee is maxing out their pretax retirement savings plan contributions and still has money to invest for retirement
- The employee has other assets they plan to live on in retirement, and plans to leave this asset to their heirs
There are other benefits of a Roth retirement account. One example is that Roth retirement accounts don’t have a Required Minimum Distribution when you reach a certain age, unlike pretax retirement accounts. However, Congress continues to increase RMD age so this may be less of a consideration in the future.
For the first two types of employee contributions to an employer-sponsored plan, there is a maximum amount you are allowed to contribute, set by the IRS. In 2023, this amount is $22,500 for those under 50.
Your employer-sponsored plan may also allow “after-tax contributions” that can be converted to a Roth election after the contribution is made.
The annual defined contribution limit in 2023 is $66,000. This includes employee and employer contributions as described above. But there is another type of contributions some employer-sponsored plans permit – after tax contributions.
The employee elects to have an after tax contribution made (above the $22,500 limit) but then immediately converts this contribution to a Roth election. This can allow the employee to save $22,500 elective deferral + employer contribution/match + after-tax converted to Roth amount = $66,000 in 2023 total contributions to the plan in one year.
Check your plan documents or talk to your plan sponsor about your employer-sponsored plan features.
Do you have questions about what type of retirement savings contributions you should be making to your employer sponsored retirement plan? Reach out to your financial advisor, or contact us to learn more about working with Tree Fort Financial.