Retirement Contribution

What Is a Retirement Contribution?

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. Qualified retirement contributions have tax benefits, depending on how much the contribution is about the contributor's income and whether the contributor has made previous contributions that would limit tax deductibility.

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).

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 in funds 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, the fund will be able to pay 76% of benefits will be able to be paid with continuing tax revenue.

Retirement Plan Features

Keep in mind that contributions made to a defined contribution plan, such as a 401(k), might be tax-deferred. In 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 totaling $6,500 for both 2020 and 2021.

If you decide to also contribute to an individual retirement account (IRA), the annual contribution limit to both traditional and Roth IRAs is $6,000 for 2020 and 2021. Those who are aged 50 and over can deposit an additional catch-up contribution of $1,000.

Types of Retirement Contributions

There are two key types of contributions — pretax and after-tax.

Pretax Contributions

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

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.

Special Considerations

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. By 2016 that number had fallen to 33%, 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 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 defined benefits pension plans) 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.