What Are Retirement Contributions?
A retirement contribution is a monetary contribution to a retirement plan. Retirement contributions can be pre-tax or after tax, depending on whether the retirement plan is qualified, 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.
- Pre-tax contributions are used to fund traditional IRAs and 401(k) plans and grow tax-deferred until retirement withdrawals (typically first eligible at age 59 1/2).
- After-tax contributions are used to fund Roth accounts and grow tax-exempt.
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 employees, the retirement contribution can have vast consequences down the road. Those who are able to 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 stocks have a good chance of funding a comfortable retirement. Those who put little or nothing aside or who invest too conservatively (e.g., money markets and low-interest bonds) are more likely to find themselves depending almost entirely on a Social Security system that is projected to run out of funds in 2035.
Keep in mind that contributions made to a defined-contribution plan may be tax-deferred. In traditional defined-contribution plans, contributions are tax-deferred, but withdrawals are taxable.
Other features of many defined-contribution plans include automatic participant enrollment, automatic contribution increases, hardship withdrawals, loan provisions, and catch-up contributions for employees age 50 and older.
Contributions to a retirement savings plan can be in the form of pre-tax or after-tax contributions. If the contribution is made with money for which an individual has already paid tax, it is referred to as an after-tax contribution. After-tax contributions can be made instead of or in addition to pre-tax contributions. Many investors like the thought of not having to paying 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 the future.
Making pre-tax contributions is beneficial to those who are eligible as it reduces the amount of taxes paid at that time. After all, it is always better to defer payments due to the time value of money.
After-Tax Contribution Plans
Unlike pretax contribution plans, the Roth IRA is an after-tax contribution plan. While taxes are paid on withdrawals from pre-tax contribution plans, tax is paid on Roth contributions now, but their earnings can be withdrawn 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, pre-tax 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.
In the Roth IRA or Roth 401(k), the account holder makes contributions after taxes, but withdrawals are tax-free if certain qualifications are met. The tax-advantaged status of defined-contribution plans generally allows balances to grow larger over time compared to taxable accounts.
Investing for Retirement
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) (called a defined contribution plan) or IRA it's up to the employee to make the investment decisions and shepherd the growth of the account.