Salary deferrals are funds taken from your regular paycheck and put into a retirement savings plan, such as a 401(k). They are most often made from pre-tax income, which allows savers to reduce the amount of their income that’s considered taxable by the Internal Revenue Service.
Learn more about salary deferral contributions and how they can help you plan for retirement.
What Are Salary Deferrals?
As the name implies, salary deferrals commonly apply to pre-tax contributions made to tax-deferred retirement accounts, including traditional 401(k) plans, for most employees of for-profit companies; 403(b) plans, for many public school employees and religious leaders as well as those who work for non-profit organizations; and SIMPLE IRA plans, which are generally set up by small businesses as a lower-cost alternative to a 401(k).
When you make tax-deferred/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 pay tax on them only when you start to make withdrawals in retirement. These withdrawals will be taxable at ordinary income tax rates, which may be lower in retirement, depending on your level of income.
Some employers enable workers to make deferrals to Roth retirement plans, such as a Roth 401(k). In contrast to the previous retirement plans, deferrals from Roth plans consist of after-tax funds. Taxes are paid upfront, and withdrawals from these plans are not taxed.
Gains from your investments grow tax-free in your retirement accounts, as opposed to in a brokerage account, where they are subject to capital gains tax.
How Do Salary Deferrals Work?
Putting money directly into a 401(k) or other savings 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.
Making pre-tax contributions to a company retirement plan also lowers your taxes for the tax year because you’re lowering your taxable income. For example, let’s say your taxable income as a single filer is $72,000, putting you in the 22% tax bracket for 2020. If you contribute $2,000 as a deferral into your 401(k), your taxable income will be lowered by that same amount. The $2,000 reduction in income will save you $440 ($2,000 x 0.22) in taxes.
You are also eligible for a 10%, 20%, or 50% tax credit on up to $2,000 of contributions to a retirement savings account, depending on your income level, if your adjusted gross income is $32,500 or less in 2020.1
One of the best reasons to make employee deferrals is to take advantage of the employer match that some companies offer. As an incentive for employees to save, some employers match all or a percentage of what you contribute to your savings plan up to a certain percentage of your salary. For example, a company might contribute 50% of what you defer from each paycheck up to 6% of your annual salary. A more generous employer might match 100% of what you contribute up to 5% of your salary.
Salary deferrals are similar to automatic transfers from a checking account into a savings account in that they can help you resist the temptation to spend much of the money that’s available to you. If you have had difficulty saving money, this disciplined approach can help get you on track with your retirement goals.
How Much Can I Contribute in Salary Deferrals?
If you are under age 50, you can defer a maximum of $19,500 into a 401(k) or 403(b) plan or $13,500 into a SIMPLE IRA in 2020.
If you’re age 50 or older, you can contribute an additional $6,500 in catch-up contributions into a 401(k) or 403(b) or an additional $3,000 into a SIMPLE IRA.
In 2020, total annual contributions from employee and employer may not exceed $57,000 or 100% of the employee’s compensation, whichever is lesser. If you’re 50 or older, the amount rises to $63,500.2
People with very high compensation may use only their first $285,000 of compensation when calculating the maximum permitted contributions from them and their employer.2
How to Make Salary Deferrals
In most cases, an employee must enroll in their employer’s retirement savings plan. The plan’s administrator will provide a description of the plan that includes a list of investment options. You will need to fill out a salary deferral election form and name a beneficiary who would receive the money in the plan if you die.
Employers may legally require employees to be 21 or older to participate, and you may have to be employed for a certain number of months or years before you can enroll and/or receive an employer match. Employers may also require you to work for them for a certain period of time before you are able to collect all of the matched contributions if you quit your job. But you can take your own contributions to the plan with you when you quit regardless of the length of time you were employed.
Some employers have a plan that automatically enrolls workers, and you must opt out if you do not wish to make salary deferrals.
If you are self-employed and don’t have employees, you may open a one-participant 401(k) plan that is sometimes referred to as a solo 401(k).
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