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Jun 14, 2023 ConnectPay

Roth vs Pre-Tax 401(k): Which is Better For Your Employees?

Roth vs Pre-Tax 401(k): Which is Better For Your Employees?

No matter how happy your employees are, chances are, they don’t want to work for you until the end of their lives — they don’t want to work at all until the end of their lives! Most employees know the importance of saving for retirement, and these programs and benefits are likely top-of-mind for many of your workers. 

And there are various ways you can help your employees take advantage of retirement plans. But what’s best for your business and your employees?

This article will help you decide which plans you want to offer. Consider Roth vs pre-tax 401K and more, and see how you can help your employees set up retirement plans that will benefit them when they eventually retire.


Roth vs Pre-Tax 401(k): The Skinny

A 401(k) is a retirement plan. An employee’s taxable income reduces by an equal amount every time a dollar is deposited – and you, as the employer, sponsor the plan. The money then grows until the employee retires.

Related Read: Why Offer a 401(k) Plan?

There are two 401(k) plan types: Roth and Pre-Tax. The main difference is when you pay your taxes. In a Roth 401(k), contributions are made after tax, and qualified withdrawals in retirement are tax-free. Pre-tax 401(k)s allow you to contribute before tax, and withdrawals at retirement are taxable.

As a business owner, you’re not required to offer these plans, but it would be a smart move if you do. Solid retirement plans are another way to attract top talent and help you become an employer of choice. Sure, it’s an investment, but it’s an investment in your employees and your business.

We all want to be financially secure when we retire. In the modern workplace, quality of life and feeling valued are important – especially if you want productive employees. Offering a robust employee benefits package and letting employees have some control over the process helps them feel secure in their jobs and able to manage their finances better.

Offering retirement plans shows your employees that you:

  • Are thinking long-term
  • Care about their futures
  • Want to help them save money and enjoy some tax advantages

Matching rates and contributions takes things a step further. 

Matching employee contributions up to a certain percentage is like giving them free money! This extra incentive will make it hard for job seekers to resist. As for current employees, knowing their employer is committed to helping them save for retirement encourages them to stick around.

Pre-Tax 401(k) Plans

Pre-tax 401(k) plans are popular for the following reasons:

  • Contributions are tax-deferred, meaning your money isn’t taxed until it is withdrawn, when you will likely be in a lower tax bracket.
  • Companies often match part or all of your contribution.
  • You don’t have to think about it once you choose to participate because deductions are automatic.
  • Because the amount you contribute is a pre-tax deduction from your take-home pay, your taxable income is reduced, so you may pay lower income tax.

The amount you can contribute to a traditional 401(k) is limited. For 2023, the maximum limit is $22,500 (pre-tax and Roth). Amounts matched by your employer are not included in this limit. Participants age 50 and older are allowed to contribute an additional $7,500 “catch-up” contribution, bringing the total allowable contribution to $30,000.

Related Read: Pre-Tax Benefits vs. Post-Tax Benefits: Understanding the Difference

After-Tax 401(k) Plans

That already sounds attractive, but some taxpayers are eligible to supersize their contributions and save even more — if their employers allow after-tax contributions to their 401(k). These plans allow you to contribute up to $43,500 more than the $22,500 limit. This means you can save $66,000 annually in an after-tax 401(k) (up to $73,500 if you are 50 or older).

Note the following tax considerations:

  • Your maximum contribution is reduced by any matching contributions.
  • Plan limits apply.
  • The plan is subject to nondiscrimination testing for highly compensated employees.
  • Your contributions are taxed in the year they are made, so your taxable income is not reduced by your contribution amount.
  • Because you’ve already been taxed on your contributions, any interest or dividends you earn grow tax-free rather than tax-deferred.

In-Plan Roth Rollover

Some employers allow participants to their traditional 401(k) plan to convert their plan to a Roth 401(k) while they are still employed at the company. Although this option is not widely available, it can be beneficial.

Certain tax events are triggered once you leave a company or retire:

  • If you have a traditional 401(k), your pre-tax contributions generally are rolled over into a traditional IRA. Any withdrawals are taxed as ordinary income.
  • If you have an after-tax 401(k), your contributions can be rolled over into a Roth IRA. You do not have to pay any taxes when you make withdrawals, because your contributions already have been taxed.

How to Decide Between Pre-Tax and Roth 401(k) Contributions

You can help your employees choose between retirement plans (if you offer multiple options). Offer them resources and advice, and help them make an informed choice. You can touch on topics like:

Tax Bracket Now vs. Retirement

Will their retirement tax bracket be higher or lower than their current tax bracket? They might benefit from a pre-tax 401(k) if they expect to be in a lower tax bracket when they retire, as they will pay lower taxes. In contrast, if they'll be in a higher tax bracket in retirement, a Roth 401(k) might be a better choice since they'll pay taxes now at a lower rate and can withdraw tax-free later.

Time Horizon

In general, the longer employees have until retirement, the more time their investments have to grow. Tax-free withdrawals from a Roth 401(k) can be a significant advantage over time, especially if their investments perform well. They might consider a Roth 401(k) if they have many years before retirement.

Flexibility and Early Withdrawals

Compared to Pre-Tax 401(k)s, Roth 401(k)s offer a bit more flexibility when it comes to early withdrawals. 

Although they may still face penalties and taxes on their Roth 401(k) earnings if they withdraw funds before age 59 ½, they can withdraw their contributions (not earnings) without penalties. Investing in a Roth 401(k) may be more appealing if your employees anticipate needing access to their contributions before retirement.

Roth vs Pre-Tax 401(k): Give Your Employees the Choice

As a business owner, giving your employees a choice is essential. Offering a mix of popular plans, like 401(k)s (both Roth and Pre-Tax), can cater to various financial situations and preferences.

Providing a variety of retirement plans can help your company attract and retain employees. However, retirement benefits are only one part of an overall compensation package. If other aspects of your compensation package are lacking, having too many options may not necessarily give you a significant edge over the competition.

It’s a lot to think about, right?

ConnectPay can help! We understand that pre-tax and post-tax deductions are tricky, and you might also be wondering how this affects payroll taxes and other laws. We can provide you with the connections you need to local tax experts who will guide you through the process so you can easily manage tax compliance.

We can also help you manage plans:

  • Deducting employee contributions
  • Keeping track of contribution limits
  • Reporting and tax filings
  • Helping with enrollment, distributions, etc.
  • Online portals to manage accounts

For more information about how we can help you manage incomes and deductions during payroll processing, tax forms, filing, and compliance, check out our free resource, The Connected Guide to Small Business Payroll.
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Published by ConnectPay June 14, 2023