Is Safe Harbor Match Pre-Tax or Roth?

The introduction of Roth 401(k) plans has added a layer of choice to retirement savings, allowing employees to decide between paying taxes now or in the future. This flexibility leads to questions about how different types of contributions are treated, and savers often wonder if employer funds, like a safe harbor match, are handled the same way. The tax nature of contributions directly impacts both current take-home pay and eventual retirement income.

Understanding whether matching funds are pre-tax or Roth is necessary for projecting future tax liabilities, and this article will explore the rules governing these employer contributions, which have recently evolved.

Understanding 401(k) Contribution Types

A 401(k) account can be funded by the employee and the employer. For their own contributions, called elective deferrals, employees with a Roth 401(k) option face a choice. They can make traditional, pre-tax contributions, which reduce their current taxable income, but these funds and their earnings will be taxed upon withdrawal in retirement.

Alternatively, an employee can choose to make Roth contributions with money that has already been taxed. This means there is no upfront tax deduction, but qualified withdrawals in retirement, including all investment gains, are completely tax-free. This decision hinges on an individual’s assessment of their current versus future expected tax rates.

Employer contributions represent a separate category of funds within the same 401(k) account. A safe harbor match is a specific formula-based contribution an employer makes, contingent on the employee’s own savings. For example, an employer might match 100% of the first 3% of compensation an employee defers. These contributions are subject to their own distinct set of tax rules.

The Traditional Tax Treatment of Employer Contributions

Historically, the tax treatment of all employer contributions, including safe harbor matches, has been on a pre-tax basis. This rule applied regardless of whether the employee’s own contributions were pre-tax or Roth. Even if an employee directed all of their savings into a Roth 401(k), the employer match would be deposited into a pre-tax portion of their account.

The rationale for this treatment is that the employer claims a business tax deduction for the matching funds. Since the employee has not yet paid income tax on that contributed amount, the funds enter the plan as pre-tax money to be taxed upon withdrawal.

Within a participant’s 401(k), these different tax treatments are managed through separate sub-accounts. An employee has different pools of money: their pre-tax deferrals, their Roth deferrals, and the employer’s pre-tax contributions. Any distributions of the safe harbor match and its investment gains are taxed as ordinary income in retirement.

The New Roth Option for Employer Contributions

The SECURE 2.0 Act of 2022 introduced a new possibility, permitting employers to amend their 401(k) plans to offer employees a choice to have matching contributions designated as Roth. This is an optional feature that a company must proactively adopt; it is not an automatic entitlement. If a plan offers this feature, employees can elect to have their safe harbor match treated as post-tax money.

Opting for a Roth match has immediate tax consequences for the employee, as the amount of the employer match is included in the employee’s gross income for that tax year. A requirement is that any employer contribution designated as Roth must be 100% vested at the time it is made. Because this is a recent development, many plan providers are still updating their systems to administer this option, so its availability remains limited.

In-Plan Roth Conversions of Employer Funds

For employees in plans that have not adopted the new Roth match feature, another strategy may be available: an in-plan Roth conversion. Many 401(k) plans permit this feature, which allows a participant to move funds from their pre-tax sources to the Roth source within the same plan. This option can be applied to the vested balance of pre-tax safe harbor matching contributions.

This action is a taxable event, and the total amount of the conversion is added to the employee’s ordinary income for the year in which the conversion takes place. The “cost” of the conversion is the immediate tax liability on the amount moved. In exchange for paying those taxes today, the converted funds and all future earnings can be withdrawn tax-free in retirement, assuming qualified distribution rules are met. This provides a tool for tax planning, especially for those who anticipate being in a higher tax bracket in the future.