Employment Taxes and 401(k)/403(b)/457(b) Contributions
Most defined contribution company retirement plans are going to consist of at least two components: the contributions the employer makes to the plan and the deferrals from salary the employee makes into the plan. Plans do not have to offer the ability to make salary contributions (called a “Cash or Deferred Arrangement” (CODA) under the Tax Code). Nevertheless, plans with CODAs, such as 401(k), 403(b), and 457(b) plans are overwhelmingly popular among the US workforce. Here, we will examine the assessment of various employment taxes to both employer and employee contributions to a plan with a CODA.
There are 3 types of federal taxes that are withheld from your wages. The tax rate and withholding rules vary among them. They are federal income tax, Medicare tax, and Social Security Tax (the last two collectively referred to as “FICA Taxes”). They are withheld at the following rates:
- Federal Income Tax – According to the Form W-4 on file. If the Form is not filed, the employer should withhold as if the taxpayer is single with zero exemptions.
- Medicare Tax – 1.45% with no cap on wages. Wages above $200,000 (single) and $250,000 (married filing jointly) are subject to an additional 0.9% Medicare Tax.
- Social Security Tax – 6.2% but capped at the Social Security Taxable Wage Base (SSTWB). For 2018, the SSTWB is $128,400.
When you earn wages, these three taxes are assessed before being paid out to you. However, as we will see, if you contribute a portion of those wages to a qualified retirement plan, the tax treatment changes slightly.
Employer contributions are not subject to employment taxes when contributed to the plan. That includes all three taxes mentioned above. Employer contributions include matching, non-elective, and profit-sharing contributions. This tax treatment applies whether the plan has adopted a vesting schedule or fully vests the employer contributions. There are two types of permissible vesting schedules: (1) a 2-to-6-year Graded Schedule or (2) a Cliff Vesting Schedule. The vesting schedule only applies to employer contributions. Employee contributions are always 100% vested when made.
Employee contributions made to qualified plans are exempt from federal income tax but are still subject to Medicare and Social Security Taxes. That means these taxes are withheld from earned wages before they are contributed to the retirement plan. On the other hand, federal income taxes are postponed, or deferred, until distribution.
For example, Jackson is a salaried employee who is paid on a bi-weekly basis (i.e., twice per month). He earns $5,000 per payroll period (a total of $10,000 per month or $120,000 per year). He elects to defer 5% of his salary to his company’s 401(k) plan. The plan contains a dollar-for-dollar match that is capped at 5% of compensation. The taxes and 401(k) contributions for each payroll period are:
- Medicare Taxes - $72.50 ($5,000 x 1.45%)
- Social Security Taxes - $310.00 ($5,000 x 6.2%)
- 401(k) Salary Deferrals - $250.00 ($5,000 x 5%)
- Employer Match - $250.00 ($5,000 x 5%)
- Federal Income Taxes - $4,750 (i.e., $5,000 less the Salary Deferral Contribution of $250) x Form W-4 Rate
Jackson would pay federal income taxes on the 401(k) contributions (both employer and employee) when he takes a distribution from the plan.
Finally, this treatment does not apply to designated Roth and after-tax contributions. Roth accounts can be added to 401(k), 403(b), and 457(b) retirement plans. After-tax contributions can be added to almost any plan. Both contributions are fully taxed when earned, as if the employee took the cash into income. That means all employment taxes would apply upfront. As a result, these contributions become basis and are not taxed when withdrawn from the plan.