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Are retirement contributions pre-tax or post-tax?

Many businesses offer a retirement plan as part of their employee benefits package. In fact, many states are beginning to set up state run retirement programs to allow employees that do not have access to a retirement vehicle the chance to begin investing in their future. While there is no shortage of retirement plan options available to employers, each one comes with a different set of rules. One of those rules regulates how contributions are made to the plan. These contributions can either be made pre-tax or post-tax. Let’s take a look at pre-tax and post-tax retirement contribution scenarios.

What are pre-tax and post-tax deductions?

Before we dive into pre-tax and post-tax retirement contributions, let’s establish what pre-tax and post-tax deductions are. When a deduction is made from an employee’s paycheck before payroll taxes are taken out, this is known as a pre-tax deduction. This lowers the tax liability of the employee.

Any deductions made after an employee’s taxes are withheld are known as post-tax deductions. These types of deductions do not have an effect on the employer or employee’s tax liability. A key thing to note, post-tax deductions do not require future tax payments.

Pre-tax retirement contributions

A pre-tax retirement contribution is any amount paid by an employee into a designated pension plan, retirement account, or another tax-deferred plan. This amount is taken from an employee’s wages before taxes are withheld. Traditional 401(k)s and SIMPLE IRAs are common small business retirement plans that allow for pre-tax contributions. Taxes are not paid on this income at the time of contribution. However, takes are paid on these contributions when withdrawals from the plan occur.

There are some clear advantages for employees to contribute to their retirement plan on a pre-tax basis. First, employees will have additional income to invest, save and spend in the short-term. This is due to the fact that contributing a portion of their earnings before taxes are withheld lowers their federal and state income tax liabilities. Second, and in theory, employees will be in a lower tax bracket in retirement age. This will result in less taxes being withheld when withdrawals from the plan are made. Finally, employees are typically able to contribute more to their retirement accounts with pre-tax contributions as opposed to post-tax contributions since they have more disposal income in the short-term.

Post-tax retirement contributions

A post-tax retirement contribution is any amount paid by an employee into a retirement plan that is not tax-deferred. Examples of these plans include Roth 401(k)s and Roth IRAs. The amount that employee contributes is taken after the employee has paid taxes on their gross income. Since taxes are paid at time of contribution, no taxes are withheld when an employee withdraws money from their retirement plan.

A perk of post-tax retirement contributions is that the employee will not have to worry about paying taxes when withdrawals are made. If an employee believes that they will be in a higher tax bracket at the time of retirement, then post-tax contributions are more advantageous. Additionally, if an employee does not think they will have as much disposal income in the future, they may want to pay taxes now as opposed to paying taxes when withdrawals are made.

How to choose between pre-tax and post-tax plans

When making a choice between retirement plan options for your business, it is important to consider all the rules of each plan. It is not wise to select a plan just because it allows for pre-tax or post-tax contributions. Other factors to consider include:

  • contribution limits
  • contribution rules
  • administrative requirements of the plan
  • cost of setting up and operating the plan

Working with a trusted payroll provider or financial advisor is key to choosing the retirement plan that works best for your business. Feel free to contact us for additional support on this topic.