What Are Retirement Contributions?
A retirement contribution is a monetary contribution to a retirement plan. Retirement contributions can be pretax or after-tax, depending on whether the retirement plan is qualified, meaning it meets the standards of the Internal Revenue Service (IRS).
Qualified retirement contributions have tax benefits, depending on how much the contribution is in relation to the contributor's income and whether the contributor has made previous contributions that would limit tax deductibility.
- Retirement contributions are funds earmarked specifically for qualified retirement accounts.
- Pretax contributions are used to fund traditional IRAs, and 401(k) plans and grow tax-deferred until retirement withdrawals.
- After-tax contributions are used to fund Roth accounts, and the funds can be withdrawn tax-free in retirement.
Understanding Retirement Contributions
In many corporate, private, and government retirement plans, an employee's retirement contribution is matched in some way by the employer. This is referred to as an employer match, rather than a contribution. For example, a 401(k) plan might allow an employee to contribute a percentage of their salary, while the employer might offer to match contributions up to 5% of the employee's salary.
For employees, the retirement contribution can have vast consequences down the road. Those who can contribute at least 10% of their income (better yet 12% or 15%) during their working lives and invest the money in a broad range of securities have a better chance of creating a sizable retirement fund. On the other hand, those who don't contribute to a retirement plan or invest too conservatively in their early years (e.g., money markets and low-interest bonds) might find themselves not having enough in retirement. As a result, those with shortfalls in funds would likely find themselves more dependent on Social Security, which is projected to run out of funds by 2035 if nothing is done to fix it.
Retirement Plan Features
Keep in mind that contributions made to a defined contribution plan, such as a 401(k), might be tax-deferred. In traditional defined-contribution plans, contributions are tax-deferred, but withdrawals are taxable. In other words, the earnings or interest on the invested funds grow tax-free over the years, but once in retirement, the distributions or withdrawals are taxed at your income tax rate.
Other features of many defined-contribution plans include automatic participant enrollment, automatic contribution increases, hardship withdrawals, and the ability to take a loan out on a portion of the balance.
Retirement Contribution Limits
There are annual contribution limits, per the IRS, for 401(k)s. For 2020 and 2021, the contribution limit—as an employee—is $19,500. If you are 50 or older, you can make catch-up contributions totalling $6,500 for both 2020 and 2021.
If you decide to also contribute to an individual retirement account (IRA), the annual contribution limits to both traditional and Roth IRAs is $6,000 for 2020 and 2021. For those who are aged 50 and over, they can deposit an additional catch-up contribution in the amount of $1,000.
Contributions to a retirement savings plan can be in the form of pretax or after-tax contributions. If the contribution is made with money for which an individual has already paid income tax on that money, it's referred to as an after-tax contribution.
However, making pretax contributions, as in the case of a 401(k), is beneficial to those who are eligible since it reduces the amount of taxes paid in the tax year of the contribution. These tax savings can be an added benefit to contributing to a 401(k) and encourage employees to save for their retirement.
Also, your income tax rate is likely to be lower in retirement than the tax rate while working. The pretax contribution lowers the person's taxes when they're earning the highest amount of money in their working years. However, the distributions in retirement are taxed, but ideally, the income tax rate will be lower than it had been during the working years.
After-tax contributions can be made instead of or in addition to pretax contributions. Many investors like the thought of not having to pay taxes on the principal when they make a withdrawal from the investment. However, after-tax contributions would make the most sense if tax rates are expected to be higher in retirement versus their working years.
Unlike pretax contribution plans like 401(k)s, the Roth IRA and Roth 401(k) are after-tax retirement products. In other words, you don't receive a tax deduction in the year of the contribution, but the investment earnings grow tax-free, and the withdrawals, in retirement, are also tax-free.
An individual who is torn between making pretax or Roth contributions to their retirement plan should compare their current tax bracket with their expected tax bracket at retirement. The bracket that they fall under at retirement will depend on their taxable income and the tax rates in place. If the tax rate is expected to be lower, pretax contributions are likely to be more advantageous. If the tax rate is expected to be higher, the individual may be better off with a Roth IRA.
Also, if you're expected to have a large sum of funds saved in a pretax 401(k), for example, it might be helpful to have funds in a Roth IRA so that, in retirement, you can split your distributions between the two accounts in case you want to lower your taxable income for that year.
Either way, the tax-advantaged status of defined-contribution plans—whether a Roth or pretax 401(k)—generally allow your money to grow by a greater rate versus taxable accounts. However, it's best to consult a financial planner and tax advisor to determine the right long-term strategy for your financial situation.
Evolution of Retirement Plans
For better or worse, the retirement contribution now forms the bedrock of America's retirement system. At the end of the 1960s, some 88% of private-sector workers who had a workplace retirement plan had a pension, according to the National Pension Public Coalition. That number by 2016 had fallen to 33%, and much of that total is accounted for by workers at various levels of state and federal government.
The decline in pensions coincided with the rise of 401(k) retirement plans that began to take off in the 1980s. The major difference between a 401(k) and a pension (also known as a defined benefits pension plan) is that with the latter, corporations and government-guaranteed a fixed payout to retirees. With a 401(k), it's up to the employee to make the investment decisions and shepherd the growth of the account.