Retirement Contribution: Meaning, Types, Limits

What Is a Retirement Contribution?

A retirement contribution is 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.

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.

Retirement contributions are often used to buy investments such as stocks, bonds, or alternative investments. Investors with many years until retirement may choose to allocate their retirement savings more aggressively, strategizing that they have more time to compensate for any future lost principle. Investors closer to retirement may strategize to conserve or maintain their retirement contributions instead.

Types of Retirement Contribution Accounts

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
• 403(b)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.

Retirement Contribution Limits

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:

• $22,500 for 2023 and $23,000 for 2024 for 401(k) plans. In addition, individuals who are 50 or older may make additional retirement contributions with a catch-up contribution each year of $7,500 for 2023 and 2024.
• $15,500 for 2023 and $16,000 for 2024 for SIMPLE plans. In addition, individuals 50 and older can make a catch-up contribution each year of $3,500 in 2023 and 2024.
• $6,500 for 2023 and $7,000 for 2024 for IRAs, with a catch-up contribution of $1,000 for each year if you are 50 or older for IRAs.
  

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 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, such as money markets and low-interest bonds, might find themselves not having enough money during retirement.

Tax Status of Retirement Contributions

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). Instead, taxes are only due upon withdrawals.

Alternatively, retirement contributions may be funded using pre-tax or after-tax funds. The primary difference here is the timing of when taxes are paid on retirement contributions (thereby driving the timing of when taxes are paid on earnings).

Pre-Tax Contributions

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.

The downside to pretax contributions is earnings do not grow tax-free. In the short term, savers recognize the tax benefits of their savings. However, they will be subject to higher taxes in the future.

After-Tax Contributions

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.

Pre-Tax vs. After-Tax Contributions

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 allows 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 has dramatically fallen, especially in the private sector. As of March 2023, only 15% of private industry workers in the United States had access to a defined benefit plan.

Workers in state and local government may find it easier to contribute to multiple types of plans. For instance, 86% of workers had access to defined benefit plans such as pensions, while 39% of government workers had access to defined contribution plans.

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.

The Bottom Line

Individuals don't usually plan on working forever. To one day stop working, transition into retirement, and continue to pay bills, individuals often rely on retirement contributions and retirement savings. Retirement contributions are the assortment of ways an individual puts money into specific types of investment vehicles to save for the future, minimize their tax liability, and strengthen their long-term financial health.