What Are Salary Deferrals in 401(k) Plans?

Learn how 401(k) deferrals can help grow your nest egg

Watering Can By Saplings On Stack Of Coins
•••

Sawitree Pamee / Getty Images

A 401(k) plan is a retirement plan that may be offered by your employer. 401(k) plans are regulated by the tax code and thus have specific rules that must be followed. One of these rules, known as salary deferral, allows you to direct funds into the plan from your paycheck. Understanding how 401(k) deferral contributions work can help you achieve financial security in retirement.

Basics of Salary Deferrals

In general, three types of contributions can be made to a 401(k) account:

  • Salary deferrals: These are amounts you elect to regularly contribute a percentage of your income or a dollar amount to a company retirement plan through payroll deductions, either before or after taxes have been taken out.
  • Catch-up contributions: Savers aged 50 or over in 2020 can contribute an additional amount above and beyond their salary deferrals.
  • Employer matching contributions: Employers can choose to make an additional contribution to an employer-sponsored 401(k) in some years that matches the employee's salary deferrals in part or whole up to a certain amount. For example, a company might choose to match dollar for dollar an employee's own salary deferrals of up to 5% of his income.

As the name implies, salary deferrals commonly apply to pre-tax contributions made to tax-deferred retirement accounts, such as traditional 401(k) plans. When you make tax-deferred contributions or pre-tax contributions, you don't pay income taxes on the deferral amount in the current tax year. Instead, you defer the taxes on contributions now and only pay tax on them when you start to make withdrawals in retirement. Although the withdrawals from tax-deferred accounts are taxable at ordinary income tax rates, these rates are likely to be lower for you in retirement than they are before retirement.

However, some plans also allow you to make after-tax contributions to Roth 401(k) plans. When you take this approach to deferrals, you pay tax on the money before it goes into the plan, so you won't pay tax on it when you later withdraw from the plan.

Benefits of Salary Deferrals

It's advantageous to defer your income to a 401(k) for a few key reasons:

It offers tax savings. Depending on whether you make pre-tax or after-tax deferrals, you can avoid taxes when you contribute or when you withdraw from the retirement plan. Pre-tax deferrals are particularly cost-effective if you expect to be in a lower tax bracket in retirement than you are in now.

It may make you eligible for an employer match. One of the best reasons to make employee deferrals is to take advantage of the employer match that some employers offer. This means if you defer some of your salary, the company contributes some of its own money to match what you contributed. The matching contributions will grow tax-free in your account alongside your contributions, amounting to a sizable nest egg upon withdrawal in retirement.

It offers a hands-off approach to saving. Putting aside money directly into a 401(k) plan from your paycheck through salary deferral contributions offers an easy and convenient way to fund your retirement without having to budget for a future contribution or write a check.

It curbs the temptation to spend your earnings. Setting up salary deferrals is similar to setting up automatic transfers from a checking account; the money automatically goes into your retirement account, so you won't be able to spend it as it hits your account. This disciplined approach can help keep you on track with your retirement goals.

How Employee Deferrals Reduce Your Taxes

Making elective contributions to a company retirement plan on a pre-tax basis reduces your taxable income in the contribution year, resulting in a lower tax bill.

For example, let’s say that your taxable income (income less deductions and exemptions) is $72,000, putting you in the 22% tax bracket for 2020. If you contribute $2,000 as a 401(k) deferral, you won't pay taxes on it because the full $2,000 will go into the plan and will not count as taxable income that year. The $2,000 reduction in income saves them taxes at the 22% rate, reducing their tax bill by $440 in total. However, you will pay taxes when you withdraw the money, and naturally, there are restrictions as to when you can take withdrawals. For example, a 10% penalty may apply if you withdraw before you reach age 59.5.

If you make the same $2,000 contribution on an after-tax basis to a Roth 401(k), you won't get the up-front tax break in the contribution year because the contribution won't reduce your taxable income. The benefit of an after-tax contribution kicks in during retirement, at which time you'll pay no tax on withdrawals from the 401(k) plan.

Salary Deferral Limits

There is a limit to how much of your income you can defer into a 401(k)plan. If you are under age 50, you can defer a maximum of $19,500 in pre-tax and Roth contributions in 2020 to all retirement plans of the following plan types: 401(k), 403(b), SIMPLE plans, and SARSEP plans.

If you're age 50 or older, you can contribute an additional $6,500 in catch-up contributions, making the limit $26,000.

In 2020, your total annual contributions to the above plan types, including elective deferrals, matching contributions, and other discretionary contributions must be the lesser of 100% of your compensation or $57,000.

The more you make, the more you'll generally need to contribute to your 401(k) and other savings vehicles in order to maintain your standard of living in retirement.

When You Should and Shouldn't Make Deferrals

As a retirement savings approach, salary deferrals to a 401(k) are appropriate when:

  • You want to take advantage of tax-free growth. Whether you make pre-tax or after-tax employee deferrals, the money grows on a tax-free basis over the span of your career. This provides a considerable advantage over putting the money into a taxable account such as a brokerage account, where capital gains taxes paid on the sale of profitable investments can eat into your returns.
  • You are meeting your living expenses and have an emergency fund. This means that you have a plan for how to pay for essential expenses, including mortgage or rental payments, healthcare insurance, utility bills, home insurance, and car insurance. You should also have an emergency fund amounting to between three and six months of income.
  • You don't need immediate access to all of their earnings. Deferrals are deducted from your paycheck and directed to your 401(k), so the low liquidity of money in the account should be acceptable to you.

In contrast, 401(k) deferrals may not be financially prudent if:

  • You're barely covering your expenses. If you're struggling to meet your expenses now, or don't have three to six months' worth of living expenses in a savings account or another easily accessible account, you may want to hold off on salary deferral contributions and work on building a financial cushion first.
  • You need easy access to your money. The early withdrawal penalties imposed on 401(k) accounts help restrict salary deferral contributions from your daily use before age 59.5. But you also need access to accounts that are not restricted. Savings accounts, for example, are a more liquid option for paying unexpected bills or accommodating changes in financial plans.

How to Make Salary Deferrals

You can start to defer income once you enroll in a 401(k) plan. Employer plans generally allow you to participate in these plans if you meet two criteria:

  • You are at least 21 years old.
  • You have at least one year of service. You may require more years of service to become eligible for matching contributions.

If your employer offers both pre-tax and after-tax employee deferrals, you will be given the opportunity to select your preferred option. The higher your tax bracket is now, the more it makes sense to make pre-tax salary deferral contributions. However, if you are in a low tax bracket or pay no tax because you have many deductions, then after-tax salary deferrals to a Roth 401(k) plan may be better than pre-tax contributions.

If you are self-employed, open a self-employed 401(k) plan and defer some of your own salary to the plan. Many brokerage firms today allow pre-tax or after-tax contributions to a self-employed 401(k) plan, allowing you to choose the one that best suits your short- and long-term goals.

The sooner you start making employee deferrals, the easier it will be to reach a minimum level of financial security needed for retirement. Remember: No matter how little or how much you earn, strive to live on less than you earn and save some of those earnings.