Employee deferrals are contributions to a plan supported by the employer that are excluded from the employee’s gross income. Individual retirement accounts (IRAs) for Roth are retirement accounts that are owned and managed individually by individuals. The contributions are not salary deferrals, but are made directly by the individual to a Roth IRA.
What is the difference between employee deferrals and Roth IRA contributions?
Employee deferrals are part of employer-sponsored defined contribution plans such as a 401(k), 457, employee stock ownership plans, or a 403(b). The employee voluntarily defers a portion of their salary, which the employer contributes to the plan on behalf of the employee. The employee can exclude elective contributions from gross income. Contributions to the account and earnings in the account are not taxed until distribution in retirement. Generally, penalties are imposed if any distributions are taken before age 59 and a half.
A Roth IRA is an individual retirement account. The individual owns and manages the account, which is held by a custodian such as a bank or brokerage firm. Your contributions are not tax-deductible, but earnings grow tax-free, and qualified distributions are also tax-free. Contributions to a Roth IRA can be withdrawn at any time without taxes or penalties.
Note: A Roth 401(k) is a hybrid retirement account: a Roth option within an employer-sponsored plan. Employee contributions to a Roth 401(k) are made with after-tax dollars.
Eligibility
Employer-sponsored plans can offer plans to different employee groups as long as the plans comply with the Employee Retirement Income Security Act of 1974 (ERISA). For instance, you may only be eligible for your employer-sponsored retirement plan if you work more than 20 hours a week, or if you have been employed with the employer for a certain period.
The ability to fund a Roth IRA is based on whether you have received compensation for the year from an acceptable income source (wages, salary, tips, self-employment earnings) and income levels. For example, if your modified adjusted gross income (MAGI) as a single applicant exceeds $129,000 for the year 2022, you may not be able to contribute to a Roth.
Contribution Limits
In 2022, you can contribute the maximum amount to all individual retirement accounts, including Roth, which is $6,000. If you are over age 50, the limit is $7,000. The maximum contribution limit is reduced if your income exceeds a certain threshold.
Participants in defined contribution plans can contribute a maximum of $20,500 or their total salary for the year 2022. Participants over age 50 may be able to make “catch-up contributions” of an additional $6,500 in specified plans.
Investments
Employer-sponsored plans offer a list of investments. The most common option is choosing mutual funds, but they may also include exchange-traded funds (ETFs) and may include employer stock. The plan sponsor (usually the employer) bears legal responsibility for reviewing the investment options provided.
A Roth IRA offers significant flexibility and often allows the individual to choose investments from a variety of options, including mutual funds, exchange-traded funds, certificates of deposit, and individual stocks.
Note: Roth IRA funds cannot be invested in life insurance or collectible items.
Loans
A loan can
Employer-sponsored plans offer loans, but the sponsoring employer is not required to do so. Loans are not available from any individual retirement account – whether Roth or traditional.
Required Minimum Distributions
Specified contribution plans are subject to required minimum distributions (RMD) by the IRS. Starting at age 72, you will be required to withdraw at least the minimum amount based on your life expectancy. There are no required minimum distributions for Roth IRAs.
Which is Right for You?
You can contribute significantly more to an employer-sponsored plan than a Roth IRA, regardless of your income level. The employer may match some or all of the employee’s contributions to the plan. For most people, employee deferrals are a more effective way to save for retirement.
Roth IRAs offer investment flexibility. Specified contribution plans typically rely on a limited list of investment options, while a Roth IRA can invest in anything except life insurance and collectibles.
A Hybrid Option
Participating in a specified contribution plan does not prevent you from contributing to a Roth IRA, as long as your income is within the required limits. If you have “fully benefited” from your contributions to the employer-sponsored plan, you may be able to enhance your retirement savings through a Roth IRA.
Conclusion
Employee deferrals are part of the specified contribution plan sponsored by the employer and are not included in your income. For most people, participating in an employer’s plan is a more efficient way to save for retirement than a Roth IRA, especially if the employer matches contributions.
Frequently Asked Questions
What is the maximum employee deferral?
Employee deferrals under a specified contribution plan are subject to section 415 of the Internal Revenue Code (IRC) and are adjusted annually based on the cost of living. In 2022, the limit is $20,500 for employees under 50, and $27,000 for employees over 50.
How can I open a Roth IRA?
Opening a Roth IRA is simple. All you need to do is choose a custodian (typically a bank, brokerage firm, or other financial institution). You will fill out a form to open the account. Decide how much you want to contribute and how you want to invest the money.
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Sources:
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editorial process to learn more about how we fact-check and ensure the accuracy, reliability, and quality of our content.
IRS. “Retirement Topics – Early Distribution Penalties.”
IRS. “Publication 590-B (2020), Distributions From Individual Retirement Arrangements (IRAs).”
U.S. Department of Labor. “Frequently Asked Questions about Retirement Plans and ERISA.”
IRS. “Publication 590-A (2021), Contributions to Individual Retirement Arrangements (IRAs).”
IRS. “Retirement Topics – IRA Contribution Limits.”
IRS. “Retirement Topics – Additional Contributions.”
IRS. “Frequently Asked Questions on IRAs.”
IRS. “Frequently Asked Questions on Loan-Related Retirement Plans.”
IRS. “Roth Comparison Chart.”
IRS. “Limits for 2022 as Presented in Section 415(d), the IRC.”
Source:
https://www.thebalancemoney.com/employee-deferral-vs-roth-ira-deferral-5270724
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