401(k) plans are some of the best retirement-saving accounts for many employees. Not only that you get tax benefits, but you may also get free money from your employer match. Employers also use 401(k) plans as a means to attract and retain talented employees. At the end of the day, everyone wins.
Common 401(k) plans include the pre-tax 401(k), Roth 401(k), and SIMPLE 401(k) plans. These plans are employer-sponsored and they offer different benefits to participants.
Whether you are an employee or employer, you need to know the key differences between these 401(k) plans before you pick one. Employers should pick a plan that meets their current and future financial goals but also offers value to their employees. Employees benefit from higher contribution limits, employer match, and tax benefits that come with 401(k) plans.
This article will walk you through the key differences between pre-tax 401(k), Roth 401(k), and SIMPLE 401(k) plans.
Why pre-tax 401(k) vs. Roth 401(k) vs. SIMPLE 401(k)?
401(k) plans are a powerful tool many companies use to hire and retain great talents. At the same time, many people settle for companies with great retirement benefits.
Whether you are a small company, a large company, or simply an employee, it is important to know the difference between different 401(k) plans. This will allow you to pick a plan that best fits your current and future financial goals.
Most employers offer a pre-tax 401(k) plan and/or Roth 40(k) plan. These plans are widely used, and therefore, the most popular among employees. Other employers can only offer SIMPLE 401(k) which is available for small employers with no more than 100 employees.
As an employee, you need to know the plan that works best for your current and retirement saving goals. If your employer offers one plan, you will not have to worry about making tough choices. However, if you are presented with multiple plans such as pre-tax 401(k) and Roth 401(k), it will be wise to analyze these plans before picking one of them. Some plans allow you to make higher contributions. Others, come with before or after-tax contributions and more flexibilities.
This article will be your complete guide to understanding the difference between traditional 401(k), Roth 401(k), and SIMPLE 401(k) retirement plans.
What is a pre-tax 401(k) plan?
Almost every employer and many employees know about this retirement plan. The pre-tax 401(k) is a retirement plan where employees who participate in the plan make contributions with before-tax wages through payroll deductions. With a pre-tax 401(k), you grow the account on a tax-deferred basis and pay income tax when you are withdrawing money during retirement.
Some employers also choose to match their employee’s contributions up to a certain percentage. For example, an employer can offer a dollar-to-dollar match of up to 6% of each employee’s gross income. Every dollar employers match to the plan is free money. For this reason, some employers use vesting schedules as a tool to keep their employees longer because none wants to leave free money behind.
When vesting schedules are employed, employees must work in a company for a given time before they are fully vested. For example, some employers require that you work in the company for 1 year before you are fully vested. Others have a gradual vesting system where you get vested over time. For example, you could get 25% of the match after 6 months of service, 50% after a year, and 100% after 2 years of service.
The key takeaways from the pre-tax 401(k) plan
- The plan comes with higher contribution limits
- The contribution comes from before-tax money through payroll deductions
- Employers may contribute to the account
- Some employers have vesting schedules
- The account grows on a tax-deferred basis
What are the benefits of a pre-tax 401(k) plan?
The pre-tax 401(k) plan is a popular retirement plan that offers a lot of benefits to both employees and employers. The following are the benefits of traditional 401(k).
- The plan can help you retain talents. Most employees stay with companies that have strong retirement benefits. By offering a pre-tax 401(k) plan, an employer can keep talented employees. Vesting schedules also help in retaining employees. Some employees don’t like to leave money on the table. So, they stay until they are fully vested.
- Higher contribution limits. The pre-tax 401(k) plan comes with higher contribution limits compared to other retirement plans. For 2024, an employee can contribute up to $23,000 or $30,500 for those who are 50 or older to their pre-tax 401(k) plans.
- Comes with a lot of flexibility. The plan can be offered together with other plans such as Roth 401(k) which adds more flexibility to both employees and employers.
- There is no limit to the number of participants. The pre-tax 401(k) has no limit to how many employees can participate. This makes it easy for companies that expect growth to sign up for this plan ahead of time instead of starting with SIMPLE 401(k) or SIMPLE IRA.
- Tax-deferred growth: Since contributions to traditional 401(k) come from before-tax money, employees grow their retirement accounts on a tax-deferred basis. In other words, employees delay paying taxes until they are withdrawing money.
- Free money through employer matching. Every matching contribution to the account is free money for employees.
- Lowers taxable income. Before-tax contributions to the account directly reduce employees’ taxable incomes.
What are the drawbacks of a pre-tax 401(k) plan?
No retirement plan is perfect. Each retirement plan comes with its benefits and drawbacks. The following are the drawbacks of a pre-tax 401(k) plan.
- Required minimum distributions(RMDs). Like other tax-deferred retirement plans, the pre-tax 401(k) comes with required minimum distributions(RMDs) when you turn the age of 73. A 25% tax may apply for the amount you withdraw on time.
- Taxable distributions. All contributions to traditional 401(k) come from your before-tax money. For this reason, participants in the plan pay income taxes when they are taking distributions.
- Higher fees. The plan comes with relatively higher fees, especially when the plan has fewer participants. The 401(k) fees vary by the number of participants and funds inside the plan.
- Too many options. Due to a lot of providers, it can be a daunting task for businesses to choose the right plan for their employees.
- Non-discrimination testing(NDTs). These are annual tests that plan providers or sponsors go through to make sure that the plan benefits all employees instead of employers or highly paid employees.
- Matching contributions are not guaranteed. Employers are not required to match their employees’ contributions to the plan.
- Vesting schedules. Employees may lose some or all unvested portions of employer matches when they leave their jobs before they are fully vested.
What are the pre-tax 401(k) contribution limits?
Every retirement plan on the market has its contribution limits. The IRS adjusts contribution limits every year in response to economic conditions.
For 2024, the maximum tax-deferred contributions to a pre-tax 401(k) plan are $23,000. If you are 50 or older you can get an extra $7,500 catch-up contribution.
In other words, if you are 50 or older, you can contribute up to $30,500.
Related: What is the 401(K) contribution limit in 2024?
What is a Roth 401(k) plan?
The Roth 401(k) is an employer-sponsored plan where your contributions come from after-tax wages through payroll deduction. This plan is a hybrid between a pre-tax 401(k) plan and a Roth IRA. For example, contribution limits to a Roth 401(k) plan are the same as a traditional 401(k) plan. However, each employee’s contribution comes from after-tax money just like a Roth IRA.
This plan does not have upfront tax benefits. However, it allows participants to not pay tax on qualified distributions from their contributions and associated earnings. The Income limits that apply to the Roth IRA do not apply to the Roth 401(k) plan. Employers can also contribute to the plan and each matching percentage is considered an after-tax. For this reason, the employee must pay taxes on the distribution associated with any tax-deferred contribution to the account. In addition, RMDs are required when you turn 72 to make tax that you pay taxes, should you delay taking your distributions.
Contribution limits to Roth 401(k) for 2024
Just like the pre-tax 401(k) plan, the Roth 401(k) plan comes with contribution limits. In 2024, the max contribution limit to Roth 401(k) is $23,000. Those who are 50 or older get an extra $7,500 catch-up contribution. That is people who are 50 or older can contribute up to $30,500.
The benefits of Roth 401(k) plan
- Vesting schedule. Employers get to keep talented employees using vesting schedules
- Flexibility. Employers can have both 401(k) plans (traditional 401(k) and Roth 401(k)) at the same time. Employees can also choose the plan that best suits them. Most employees end up choosing traditional 401(k) over Roth plans due to direct tax benefits.
- Higher contribution limits. 401(k) plans come with higher contributions than other retirement plans such as SIMPLE plans or individual retirement accounts(IRAs). For 2022, you can contribute up to $20,500 or $27,000 if you are 50 or older.
- No limit to the number of employees. There is no limit to the number of employees who can join the plan.
- Employer Match. Some employers choose to match their employee’s contributions up to a certain percentage. Any employer match is free money to your account.
What are the drawbacks of Roth 401(k) plans?
- Too many options. There are a lot of 401(k) plan providers. Choosing one can be difficult for many employers
- Required minimum distributions(RMDs). Just like other tax-deferred retirement plans, the Roth 401(k) requires that you start taking RMDs when 72. RMDs are mandatory withdrawals you need to make every year from your retirement account. Failure to take RMDs may result in a 50% excise tax on the money you did not distribute.
- Yearly non-discrimination tests. There are many non-discrimination tests every year for the plan to make sure it benefits all employees.
Pre-tax 401(k) plan vs. Roth 401(k) plan
Both pre-tax 401(k) and Roth 401(k) are employer-sponsored plans. However, there is a big difference when it comes to tax savings. The following is the comparison of the traditional 401(k) plan vs. the Roth 401(k).
| Features | Roth 401(k) | pre-tax 401(k) plan |
| Income limits | There are no income limits to participate | There are no income limits to participate |
| Contribution limits | For 2024, employees can contribute up to $23,000 or $30,500 for those who are 50 or older | For 2024, employees can contribute up to $23,000 or $30,500 for those who are 50 or older |
| Tax on withdrawals | Qualified withdrawals from your contributions and associated earnings are not taxed. A qualified withdrawal from an account you had for at least 5 years and you must be at least 59½. If you are under 59½, your withdrawal must be taken due to disability or after death. | You pay income tax on withdrawals and associated earnings |
| Required minimum distributions | Starting from 2024, RMDs are no longer required for the Roth 401(k) and Roth403(b) when you turn 73. | RMDs are required when you turn 73. If you are still working and don’t own 5% or more of the company, you can delay RMDs until you retire. |
| Tax on contributions | Contributions come from after-tax money through payroll deductions | Contributions come from before-tax money through payroll deductions |
More details: 401(k) vs Roth 401(k): What is the difference?
What is a SIMPLE 401(k) plan?
The SIMPLE 401(k) plan is an employer-sponsored plan for small employers of no more than 100 employees. This plan has some similarities to pre-tax 401(k) and SIMPLE IRA. The employer can determine who is eligible to participate and some plans offer SIMPLE 401(k) loans. Employers must file Form 5500 every year.
Just like the SIMPLE IRA, the SIMPLE 401(k) comes with mandatory employer contributions. Also, all employer match is 100% vested immediately.
Pre-tax 401(k) vs. Roth 401(k) vs. SIMPLE(401k) plans
All these three plans are employer-sponsored but they are different from one another. The key differences between pre-tax 401(k), Roth 401(k), and SIMPLE 401(k) are related to tax benefits, contribution limits, number of employees, and matching requirements.
The following are the key differences between the pre-tax 401(k), Roth 401(k), and SIMPLE 401(k).
| Features | Roth 401(k) | SIMPLE 401(k) | pre-tax 401(k) |
| Income limits | There are no income limits to participate | The plan is for small businesses with no more than 100 who earn more than $5,000 every year. | There are no income limits to participate |
| Contribution limits | For 2024, employees can contribute up to $23,000 or $30,500 for those who are 50 or older | For 2024, an employee can contribute up to $16,000. Those who are 50 or older can contribute up to $19,000 | For 2024, employees can contribute up to $23,000 or $30,500 for those who are 50 or older |
| Employer Match | An employer can choose to match employees’ contributions up to a certain percentage | The plan is for small businesses with no more than 100 who earn more than $5,000 every year. | An employer can choose to Match employees’ contributions up to a certain percentage |
| Tax on withdrawals | An employer is required to either make a matching contribution of up to 3% of each employee’s pay or a non-elective contribution of 2% of each eligible employee’s pay. | You pay income tax on your withdrawals. A 10% penalty may apply if you are under 59½ | You pay income tax on withdrawals and associated earnings |
| Required minimum distributions | Starting from 2024, RMDs are no longer required for the Roth 401(k) and Roth403(b) when you turn 73. | RMDs are required when you turn 73 | Qualified withdrawals from your contributions and associated earnings are not taxed. A qualified withdrawal comes from an account that is at least 5 years and you must be at least 59½. If you are under 59½, your withdrawal must be taken due to disability or after death. |
| Vesting schedules | Vesting schedules may apply | Employer contributions are immediately vested 100%. | Same as Roth 401(k) |
| Tax on contributions | Contributions come from after-tax money through payroll deductions | Pre-tax contributions | Contributions come from before-money through payroll deductions |
What are the contribution limits to the SIMPLE 401(k) plan?
For 2024, the contribution limit to the SIMPLE 401(k) plan is $16,000. Those who are over 50 or older get an extra $3,000 catch-up contribution. That is if you are 50 or older, you can contribute up to $19,000 to your SIMPLE 401(k) plan.
These contribution limits are much lower than contribution limits to traditional 401(k) where the limits are:
- $23,000 or
- $30,500 if you are 50 or older.
Besides employees’ contributions, the employer is required to contribute to the plan. An employer can choose one of the following options.
- Non-elective contribution of 2% of the year compensation for all employees who made over $5,000.
- Matching contribution(dollar-to-dollar) up to 3% of each employee’s pay
What are the benefits of the SIMPLE 401(k) plan?
- Possibility of loans. Some SIMPLE 401(k) plans come with loan options which are great for employees.
- Flexibility. Employers can design the plan’s eligibility like a traditional 401(k) plan.
- No heavy non-discrimination testing. SIMPLE 401(k) plans are not subjected to heavy non-discrimination testing that applies to traditional 401(k) plans.
What are the drawbacks of the SIMPLE 401(k) plan?
- Lower contribution limits. The contribution limits are much lower than the traditional and Roth 401(k) plans.
- Size restrictions. The SIMPLE 401(k) plan is strictly permitted for employers with 100 or fewer employees. Growing companies end up outgrowing the plan faster.
- Less flexibility. The plan does not allow employers to have other plans at the same time.
- Mandatory employer match. Employers are required to make mandatory contributions to the plan every year. Each employer can choose either a:
- Non-elective contribution of 2% of the year compensation for all employees who made over $5,000, or a
- Matching contribution(dollar-to-dollar) up to 3% of each employee’s pay
- Immediate vesting. Employer’s contributions to the plan are immediately vested 100%. Vesting schedules force some employees to stay with companies until they are fully vested. Since the SIMPLE 401(k) does not permit vesting schedules, some employers can easily lose talents.
Final words
The three 401(k) plans are all employer-sponsored. However, pre-tax 01(k) and Roth 401(k) are more common for large or growing employers. The SIMPLE 401(k) plan is specifically designed for small employers with 100 employees or less.
The pre-tax 401(k) and Roth 401(K) plans come with larger contribution limits ($23,000 or $30,500 when 40 or older) and employers are not required to match their employees’ contributions. The SIMPLE 401(k) plan, on the other hand, comes with lower contribution limits ($16,000 or $19,000 when 50 or older). In addition, employers have a mandatory contribution to the plan.
The plan an employer chooses depends on the size and the outlook of the business in general. For example, some fast-growing businesses avoid SIMPLE 401(k) when they think they will outgrow the plan in a few years.
Employees also make choices based on the options they have and their unique financial goals. For example, people who think they will earn more money in retirement prefer the Roth 401(k) over the pre-tax 401(k) plan. This allows them to lower their tax liabilities during retirement.
