How 401(k) Deferrals Are Different From Roth

What are pre-tax 401(k) deferrals? What are Roth contributions? We'll explore both here so you can make an informed decision about offering them in your retirement plan.

What are 401(k) deferrals?

Pre-tax elective contributions (most commonly referred to as 401(k) deferrals, but not always) are amounts contributed to a plan by the employer at the employee's election that are excludable from the employee's gross income. Pre-tax elective contributions may be contributed to a 401(k) arrangement, a 403(b) plan, a 457 plan, or other less complex plans (SIMPLE IRA, SIMPLE 401(k), etc.).

IRC §402(g) limits an individual's pre-tax elective contributions that can be made for a calendar year. Since these contributions are pre-tax contributions, they are not treated as basis for tax purposes. These contributions are tested for nondiscrimination in the actual deferral percentage (ADP) test under IRC §401(k).

What are Roth deferrals?

In a nutshell they are employee contributions that are made (elected) on an after-tax basis to their retirement account in the employer's plan.

"Designated Roth contributions" (Roth deferrals herein) are types of elective contributions that are made on an after-tax basis (not to be confused with after-tax contributions) and are subject to special taxation rules on distribution.

Designated Roth contributions and pre-tax elective contributions (collectively referred to as “elective deferrals”) are subject to both the contribution limits under IRC §402(g) and the rules under IRC §401(k).

The Major Difference Between Pre-Tax And Roth Contributions

Taxation. The rules for taxing designated Roth amounts and the earnings thereon when they are distributed are different from those for pre-tax elective contributions. Unlike a distribution from a pre-tax elective contribution account source, the entire distribution from a designated Roth account source may be completely tax-free if certain conditions are met.

Why Your 401(k) Plan Needs Both

1. It costs you nothing.

Roth deferrals are not employer contributions; as such, they do not cost the company money. As discussed above, Roth contributions are contributed to a retirement plan after taxes and are elective deferrals. Participants elect to defer from their take-home pay a dollar amount or percentage of pay.

2. Your competitor offers it.

More than likely your competitors offer Roth contributions. Tip the scales in your favor when recruiting new hires and use your robust retirement plan as a 'better-than-theirs' benefit.

3. Options are empowering.

Defined contributions plans are named so because the contributions participants elect to contribute define their retirement. Offering additional options for your employees gives them even more control over their retirement future. Empower your employee participants with more than one option for saving. Plus, those options are not 'one-or-the-other' as a participant can elect Roth, Pre-Tax, or a combination of the two to contribute to the plan.

Disclaimer: This post includes some information on taxation surrounding plan contributions. While we have done our research please understand that this information is not tax advice. Always consult your advisors and tax professionals on what options work best for you when it comes to contributing to your retirement account.