Pre-tax vs. Roth 401(k) contributions – a guide for participants

Contributing to your employer’s 401(k) plan is a great way to save for retirement, but the type of contributions you choose can have a huge impact on your finances both for now and for the future. The issue is, most employees don’t understand the differences between the Pre-tax 401(k) and the Roth 401(k), or the impact such a decision will have on their later years.

There are several similarities.

Pre-tax and Roth 401(k) contributions are both deducted from payroll, so they are contributed throughout the year, rather than in one lump-sum. Both are invested for a long period of time, and the earnings are not taxable to you while they are invested. They have the same annual contribution limits (currently $19,500 a year for workers under 50 and $26,000 a year for those 50 and over).

This is an annual, individual limit, meaning the limit applies to the total of all contributions, no matter if pre-tax or Roth contributions, or a combination of the two. Both may have distribution options available to you while still employed, depending on the plan design, and both may receive a match from the employer, again, depending on the plan design.

The main difference between Pre-tax and Roth 401(k) contributions is the timing of the taxation – when tax is paid.

A Pre-tax 401(k) contribution is deducted before federal withholding taxes are calculated. They are still subject to FICA and Medicare taxes, but reduce your current taxable income. This means that on a paycheck of $1,000 with a 10% deferral, you are taxed on $900. Over the course of a year, this can result in a large tax savings if you are in a higher tax bracket. When you take those funds out later in life, the money you distribute is taxed as standard income.

A Roth 401(k) plan is an after-tax contribution. Using the same example above of a paycheck of $1,000, your withholding taxes are calculated on $1,000. When you access those funds at retirement, both the contributions and the earnings thereon are distributed completely tax-free, assuming certain criteria are met. You must be at least age 59 ½, and it must be at least five years from your first Roth 401(k) contribution in order to distribute tax-free. If you distribute the funds prior to the criteria being met, the income on those funds is taxable and subject to the 10% excise tax on premature distributions. Unlike Roth IRAs, Roth 401(k) accounts are subject to the minimum distribution requirements. They must be rolled out of the plan and over to a Roth IRA by the time you reach age 72, or terminate employment, whichever is later, so the minimum distribution rules do not apply. For owners or certain members of their family, the account must be rolled out prior to reaching age 72, even if you continue to work.

Which Plan is right for you?

Whether you contribute to a Pre-tax or Roth 401(k) account depends on your personal circumstances. Here are a few things to consider helping you make the right choice.

  • Your age and the age you plan on retiring; a large part of the decision is to determine how long the funds will be invested and will the bulk of the money at retirement age be your own contributions or the earnings on those contributions. It may make sense to pay the tax on the contributions now in order to take out the earnings tax-free
  • Your ability to make contributions; if the tax savings allows you to make a greater contribution now, the pre-tax method may make more sense for you. At a tax bracket of 15%, a Pre-tax deduction of $100 feels like $85, but a Roth deduction feels like $100. If you would make the same contribution either way, then paying the taxes on the contributions now so you don’t pay taxes on future distributions may work out better for you in retirement.
  • Your current and expected future income; if you are just starting out in a field that will pay a much higher salary in the future, the current deduction may not make a difference to you now and will start the five year clock running, while you may want the deduction in the future.
  • Your expected tax bracket when you retire; if the tax rate stays the same, then the net effect is the same either way. If your tax rate changes and you would hope to be in a lower tax bracket in retirement, the Pre-tax account gives you the benefit of the reduction of income now while you pay less in taxes in retirement.
  • Your expected financial needs and other sources of income when you retire; keep in mind, any employer contributions (and the earnings thereon) will always be taxable to you when you receive them. Your tax professional may suggest taking all your non-taxable income first, or a combination of both in order to minimize your taxes based on your other income or financial needs.

In Conclusion:

The decision to make Pre-tax or Roth 401(k) contributions can be especially complex and vary from individual to individual. The decision should essentially be based on expectation of future income, needs and projected taxes. Don’t let the complexity keep you from contributing at all. The beauty of the situation is that nothing is carved in stone forever, your elections can be changed at least annually, depending on the rules of the plan. The most important thing is to start making contributions as soon as possible, as delays in contributions have a greater opportunity cost than any tax ramifications.

Feel free to ask your plan’s administrator, investment advisor or your own tax consultant to see what would be most beneficial to you.

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Big Changes for Safe Harbor 401(k) Plans under the SECURE Act

The 401(k) plan has quickly become the preferred retirement plan offered by most businesses today. Under the Safe Harbor Plan Design, plan sponsors can eliminate the 401(k) and 401(m) discrimination tests by providing certain minimum contributions: either by matching an individual employee’s contribution or making contributions to all eligible employees.  The SECURE Act, passed as part of Further Consolidated Appropriations Act late last year, made significant changes to rules related to Safe Harbor Non-elective contributions (the contributions to all employees approach), generally reducing the administrative burden and providing employers with greater flexibility.  Although these changes are effective for plan years beginning after December 31, 2019, the IRS has not provided guidance or updated the applicable regulations. As a result, plan sponsors may want to wait until guidance has been issued before making certain changes to their plans.


Caution: The law changes discussed below have no impact on plans that provide for Safe Harbor Matching contributions.  There were no changes made to the rules applicable for these plans.

What changes were made?

  • The annual participant notice requirement was eliminated for plans that provide for Safe Harbor Non-elective contributions.
  • Employers now have the option of adding a 3% Safe Harbor Non-elective contribution (used to satisfy the ADP test) up to 30 days before year-end without providing the advance “maybe” or follow-up notice.
  • Additionally, employers now have the option of adding a 4% Safe Harbor Non-elective contribution after the 30-day deadline but on or before the deadline for correcting ADP testing failures (the last day of the following plan year) so that the ADP test is deemed satisfied.

If the plan provides for additional matching contributions intended to satisfy the ACP Safe Harbor requirements, do they still need to provide the annual Safe Harbor Notice?

Yes, if the plan is designed so that any matching contributions (fixed or discretionary) will satisfy the requirements to be exempt from the ACP test, the Safe Harbor notice would still be required.

If an employer makes a permissible change to an existing Safe Harbor Non-elective contribution plan mid-year, do they need to provide an updated Safe Harbor notice?

It does not appear so, given the plan doesn’t also provide for matching contributions intended to satisfy the ACP Safe Harbor requirements. Presumably, this also means that participants will not be required to be provided the opportunity to make changes to their deferral elections prior to the change, but the IRS has not yet provided updated guidance on this point.

Can an employer remove their current Safe Harbor Non-elective provision and take a “wait and see” approach?

It appears so, absent future IRS guidance to the contrary. While the new law specifically prohibits a plan that provided for Safe Harbor matching contributions at any time during the plan year from adopting a Safe Harbor Non-elective contribution retroactively for that same year, it makes no such distinction with respect to plans that provided Safe Harbor Non-elective contributions for a portion of the plan year.

Keep in mind, the plan would still need to meet the regulatory requirements to reduce or suspend the Safe Harbor Non-elective contribution mid-year, and again, the IRS has not yet updated the regulations. Apparently, the pre-plan year notice (regarding the employer’s right to reserve the ability to reduce or suspend Safe Harbor contributions mid-year) and the 30-day advance (mid-year) notice would not be required since the general notice requirement was eliminated. Participants will no longer need the option to make changes to their deferral elections prior to the change.  The plan sponsor would still need to make the Safe Harbor Non-elective contribution through the effective date of the amendment.  We anticipate additional guidance from the IRS on this issue. Hopefully, it will come sooner rather than later.

How does the new 4% Safe Harbor Non-elective contribution work?

Under the new rules a traditional 401(k) can be amended after the 30-day deadline but any time on or before the last day of the following plan year to provides for a 4% Safe Harbor Non-elective contribution so that the ADP test is deemed to be satisfied. Essentially, this change allows any traditional 401(k) plan to be a “maybe” Safe Harbor plan, without any participant notice requirements. This affords plan sponsors much greater flexibility, giving them the ability to amend the plan after the ADP test has been performed so they can weigh the cost of the 4% Safe Harbor contribution against the refunds that would otherwise be issued to the plan’s highly compensated employees.

Does a plan that adopts a 4% Safe Harbor Non-elective contribution retroactively for the prior year have to make a 4% Safe Harbor Non-elective contribution for the current year?

No, the Safe Harbor contribution would only be required for the prior year. The employer could still take a “wait and see” approach for the current year or amend the plan to the 3% Safe Harbor Non-elective contribution if amended before 30 days prior to the end of the current Plan Year. If the employer wants to change from the Safe Harbor Non-elective contribution to the Safe Harbor Match, they must wait till the beginning of the next plan year.

Were there any other changes to Safe Harbor plans?

Yes. Automatic Enrollment plans that use the Qualified Automatic Contribution Arrangement (QACA) Match have changed as well. The SECURE Act increased the maximum default deferral rate from 10% to 15% for QACA Safe Harbor plans, and, changed the cap on the maximum auto-escalation percentage from 10% to 15%.

How can I learn more?

If you would like to learn more about the new rules, please contact your EJReynolds’ Consultant.