What Is a Retirement Contribution?
The term retirement contribution refers to a monetary contribution made to a retirement plan. Retirement contributions can be pretax or after-tax, depending on whether the retirement plan is qualified. Taxpayers can set aside their money to a variety of different retirement accounts but are limited as to how much they can set aside to their accounts each year. Qualified retirement contributions have tax benefits depending on certain circumstances, including the amount, the taxpayer's income, and previous contributions.
- Retirement contributions are funds earmarked for qualified retirement accounts.
- Contributions can be made to any number of accounts, including IRAs and 401(k)s.
- Pretax contributions are used to fund traditional IRAs and 401(k) plans and grow tax-deferred until retirement withdrawals.
- After-tax contributions fund Roth accounts, from which funds can be withdrawn tax-free during retirement.
- The IRS limits how much money individuals can contribute to retirement accounts each year.
Understanding Retirement Contributions
Retirement accounts allow individual taxpayers to set aside money while they work to save for retirement. The money deposited into these accounts is called a retirement contribution. Contributions can be made by individual taxpayers, including those who are self-employed. Employers can also make contributions to their employees' accounts, which are usually matched up to a certain limit.
Contributions can be made on a pre-tax or after-tax basis (more on this below) to any number of retirement accounts, which can be set up by the taxpayer or an employer. These accounts include:
- Individual retirement accounts (IRAs), including traditional, Roth, SEP, and SIMPLE IRA accounts
- 401(k)s, including traditional and SIMPLE 401(k)s
- 457 plans
The type of account a taxpayer contributes to (and their structure) depends on their personal situation. Some individuals may have more than one retirement account. For instance, someone who works with a Fortune 500 company may be able to contribute to their employer's 401(k) plan (and receive matching contributions, if the employer provides them). This person may also have a traditional IRA to which they can contribute each year.
Keep in mind that the Internal Revenue Service (IRS) limits how much taxpayers can contribute to their retirement accounts each year regardless of how many accounts they hold. The annual contribution limits are:
- $19,500 for 2021 and $20,500 for 2022 with a catch-up contribution of $6,500 for each year if you are 50 or older for a 401(k)
- $13,500 for 2021 and $14,000 for 2022 with a catch-up contribution of $3,000 for each year if you are 50 or older for SIMPLE plans
- $6,000 for 2021 and 2022 for IRAs with a catch-up contribution of $1,000 for each year if you are 50 or older for IRAs
Contributions made to a defined contribution plan, such as a 401(k), might be tax-deferred. This means you don't pay taxes on the money you deposit into a retirement account, such as a 401(k). Withdrawals, on the other hand, are subject to taxation. 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 may include automatic participant enrollment, automatic contribution increases, hardship withdrawals, and the ability to take a loan out on a portion of the balance.
Those who can contribute at least 10% of their income (or more if possible) during their working lives and invest the money in a broad range of securities (for diversification purposes) have a good 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 money during retirement.
As a result, those with shortfalls would likely find themselves more dependent on Social Security trust funds for retirement benefits—where the Old-Age and Survivors Insurance (OASI) Trust Fund is projected to be depleted by 2033 (per the 2021 Social Security Board of Trustees report). After that time, 76% of benefits will be paid out with continuing tax revenue.
Types of Retirement Contributions
As noted above, contributions to a retirement savings plan can be in the form of pretax or after-tax contributions. We've noted some of the key information below.
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.
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.
You can make both pretax or after-tax contributions—or both.
After-tax contributions are made with money on which someone has already paid taxes. Many investors like not having to pay taxes on the principal when they make a withdrawal from the investment. However, after-tax contributions 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 you contribute. Instead, the investment earnings grow tax-free and the withdrawals during 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. Their bracket at retirement depends on their taxable income and the tax system at the time. If the tax rate is expected to be lower, pretax contributions will be more advantageous. If the tax rate is expected to be higher, the individual may be better off with a Roth IRA.
If you're expected to have a large sum of money saved in a pretax 401(k), for example, it may help to have funds in a Roth IRA so that you can split your distributions between the two accounts in case you want to lower your taxable income for that year during retirement.
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.
History of Retirement Contributions
The retirement contribution is a huge foundation of America's retirement system. In the mid-1970s, roughly 88% of private-sector workers who had a workplace retirement plan had a pension. That number fell to 33% by 2016 and much of that total is accounted for by workers at various levels of state and federal government. As of 2020, only 12% of private-sector workers had access to both a defined contribution and pension plan.
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-benefit pension plan) is that with the latter, corporations and the government guarantee 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.