Although many will agree that saving for retirement is an excellent financial move, a significant number of employees still do not participate in their employer-sponsored retirement plans. The lack of participation can be the result of having insufficient income to make retirement contributions. However, many times, employees don't participate because they're unaware of the benefits and rules of these plans.

Below, we'll look at some of the advantages of making salary-deferral contributions to employer-sponsored plans, such as 401(k)s and 403(b)s.

Key Takeaways

  • Many employees don't participate in employer-sponsored retirement plans, due to lack of funds to contribute or lack of information about the benefits of participating.
  • Employees who do participate benefit from lower taxable income, from tax-deferred earnings growth, and from deferred taxes.
  • Many employers offer an employee-matching fund in which they match a small percentage of what an employee has saved in a retirement fund.

1. It Reduces Your Taxable Income

Contributions to your employer-sponsored plan are usually made on a tax-deferred basis. Tax-deferred means that your taxable income for the year is reduced by the amount you contribute to the plan. For example, say that your tax filing status is "single" and your taxable income for the year is $31,000. If you contribute $2,000 to your 401(k) account, your taxable income will be reduced to $29,000, and the amount of taxes you owe will also be reduced.

In 2020, the contribution limit for employees who participate in a 401(k) plan was increased by the Internal Revenue Service (IRS) from $19,000 to $19,500.

Of course, you'll eventually get taxed on the money when you withdraw it in retirement. However, you're likely to be in a lower tax bracket as a retiree, meaning you'll pay less tax on the $2,000 than you would've paid, had you not chosen to defer it to your retirement account.

Salary deferral contributions to non-IRA based plans, including designated Roth Accounts, can also be made on an after-tax basis. In such cases, these contributions do not reduce your taxable income.

2. Earns Tax-Deferred and Defer Income Taxes

Another benefit of saving with a tax-deferred retirement plan is that the earnings on investments are also tax-deferred. This means that you will not pay taxes on your earnings, regardless of their value, until you make a withdrawal from the plan. You, therefore, have some control over when you pay taxes on those earnings, which in turn could affect how much tax you pay.

For instance, you can choose to make withdrawals in years when your income is lower, which may mean, again, that you are in a lower tax bracket. On the other hand, if you chose to invest the amount in an account that is not tax-deferred, you would owe taxes on the earnings the year the earnings are accrued.

The amount withdrawn from a plan on a yearly basis will determine, in part, which tax bracket you'll fall into in retirement. It's important to consider other income sources, such as Social Security income when deciding how much you want to withdraw from an IRA. Your total income, including the IRA withdrawal, will determine your overall tax rate for that year.

An individual is allowed to make withdrawals from a qualified plan, as long as they meet certain requirements, as defined under the plan. For example, a participant must be over the age of 59½ to begin withdrawing distributions from a 401(k). If a distribution is taken before the age of 59½, there will be penalties, including a 10% tax by the IRS on the amount distributed. Also, the distribution will count as taxable income, meaning it'll be taxed at the employee's marginal tax rate or income tax rate.

Also, after the age of 72, you must begin distributing funds annually from the 401(k), which are called required minimum distributions (RMDs). However, the amount of the RMD is calculated by the IRS, based in part, on the total amount of your retirement savings.

All of these factors need to be considered before determining the amount to distribute from a 401(k) plan. It's best to consult a tax planning or financial planning professional to help you formulate a tax and income strategy that's best for you.

3. You Get Free Money

Many employers include matching-contribution provisions in their 401(k) or SIMPLE IRA plans. If you are a participant in such a plan and you are not making salary-deferral contributions, you could be losing the benefits offered by your employer. At a minimum, you should consider contributing up to the maximum amount your employer will match. Not taking your employer's offer to match contributions means you'll miss out on free money.

Like your own contributions, the matching funds from your employer accrue earnings on a tax-deferred basis and are not taxed until you withdraw the amount from your retirement account. Below, we'll look at another example examining John's situation.

Example

John works for ABC Company, which agrees to make a matching contribution of 50 cents on every dollar, up to a sum equal to 6% of each employee's compensation. John's compensation is $31,000 per year, of which 6% is $1,860. If John contributes $2,000 from his paychecks throughout the year, John will receive an additional $1,000 contribution to his 401(k) account from ABC Company (50% of $2,000). If John wants to receive the maximum 6% of his compensation ($1,860) that ABC would contribute to his 401(k) account, John must contribute $3,720 per year.

If John had chosen not to make any salary-deferral contributions, he would lose not only the opportunity to reduce his taxable income and the benefit of tax-deferred growth but also the matching contribution from his employer.

Please bear in mind, that a plan may require that an employee complete a certain number of years of service at the company before the employer contributes matching funds to the 401(K)—a process called vesting. Your funds become 100% vested once you complete the necessary years of service, which means you don't own the contributed funds by the employer until you're vested. However, any amounts that you contribute are immediately 100% vested.

The Bottom Line

As you can see, there are many benefits to making salary-deferral contributions to your employer-sponsored plan. If your employer does not offer a plan with such a feature, consider funding an individual retirement plan (IRA) instead. Or, if you have the option and can afford it, contribute to both an IRA and your employer-sponsored plan.

Contributing to your retirement plan helps ensure a financially secure retirement. As always, consult with your tax professional for assistance in making decisions on financial matters.