What are 401(k)s and other salary deferral plans?
401(k), 403(b), and 457 may not be very descriptive names, but these employer-sponsored salary deferral retirement plans offer strong tax incentives to save for retirement.
These retirement plans allow workers to save and invest for retirement by setting aside some of their salaries for that purpose. By participating in a plan, you can receive tax benefits while giving your money the opportunity to grow.
Most salary deferral plans also give you a degree of control over your money. You determine how much you would like to invest in each of the plan’s investment options.
Here are some retirement plan basics:
Plans in which employees contribute to their accounts, also called salary deferral plans, include:
- 401(k)s — generally sponsored by public and private companies
- 403(b)s — sponsored by nonprofit organizations, such as hospitals, schools and religious organizations
- 457(b)s — for government employees
- SIMPLEs — for small businesses
If you contribute to an employer-sponsored salary deferral plan, money will be transferred directly from your paycheck to your selected investment options. It’s easier to save when the investing is done for you automatically.
In 2020, you can contribute up to $19,500, or if you’re 50 or older, up to $26,000 to a 401(k), 403(b) or 457(b) plan. If your 401(k) or 403(b) plan accepts Roth contributions, limits apply whether contributions are pretax, Roth after-tax, or a combination of both. (Your plan’s rules may vary.) If you’re in a SIMPLE plan, you can contribute up to $13,500. For those over 50, the maximum contribution is $16,500.
Take advantage of tax benefits when you save for your retirement through salary deferral plans.
Traditional pretax contributions to retirement plans provide tax-deferred benefits. First, you won’t have to pay income taxes on your contributions at the time you contribute. Instead, withdrawals are subject to income tax. Getting a tax break on your contributions can help you save more.
Second, you won’t have to pay taxes on your earnings until withdrawn. So the taxes that you would have paid on earnings stay in your account.
See the impact that tax savings on pretax contributions can have on your paycheck with our payroll deduction analyzer.
Roth after-tax contributions may be accepted by 401(k) or 403(b) plans. Roth 401(k)s and 403(b)s can provide tax-free withdrawals. Contributions are made with money that’s already been taxed, but no income taxes are paid on qualified distributions, including any earnings.* Find out more about Roth contributions if your employer offers the option.
Tax penalties typically apply if you make withdrawals before the age of 59½, but there are some exceptions.
Some employers contribute money, or “match,” a percentage of the employee’s contribution.
If your plan offers a match, don’t turn it down. Your employer is basically giving you money. If the match is made with shares of company stock, consider diversifying the rest of your account.
Some employers contribute a non-matching contribution that you may be entitled to even if you don’t contribute. See your summary plan description for details about your plan.
In a salary deferral plan, you are always 100 vested in your own contributions. However, you’re often required to work for your employer for a certain length of time to become vested in any employer contributions.
If you leave the company before becoming fully vested, you may forfeit part or all of the employer contribution. If you’re fully vested when you leave the company, the entire employer contribution is yours.
If you don’t need the money right away, consider transferring your assets into a rollover IRA or, possibly, into a new employer’s plan. This can allow you to delay applicable taxes, avoid possible penalties and continue benefiting from tax-advantaged growth potential. You may also be able to leave your assets in your former employer’s plan if your balance is large enough. Cashing out of your salary deferral plan is an option, but you’ll have to deal with the tax consequences. Check with your employer for more details.
* Withdrawals from Roth accounts are tax- and penalty-free if the account was established at least five years before, and if the participant is at least 59½ years old, has died or is disabled. For nonqualified distributions, earnings are taxable and may be subject to a 10% early withdrawal penalty.
Investments are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so they may lose value.
Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the fund prospectuses and summary prospectuses, which can be obtained from a financial professional or downloaded and should be read carefully before investing.