Salary Reduction Contribution

What Is a Salary Reduction Contribution?

A salary reduction contribution is a contribution that is made to a retirement savings plan, which generally represents a percentage of an employee's compensation. With some plans, salary reduction contributions (also known as elective deferral contributions) may also take the shape of a specific dollar amount contributed to an employer-sponsored retirement savings plan, such as a 401(k), 403(b), or a SIMPLE IRA.

Typically, the saver or employee defers paying taxes on their contributions until they take distributions or withdrawals in retirement. As a result, the funds that have been saved grow in a tax-deferred manner.

Key Takeaways

  • Salary reduction contributions represent a percentage of an employee's pay that's deducted and contributed to a retirement plan.
  • Salary reduction contributions may apply to 401(k), 403(b), or SIMPLE IRA plans. 
  • The contributions are typically pre-tax, meaning they reduce taxable income upfront while distributions are taxed in retirement.
  • The salary reduction contribution limit for SIMPLE IRAs is $13,500 in 2021 (increasing to $14,000 in 2022), and for 401(k)s is $19,500 in 2021 (increasing to $20,500 in 2022).
  • For those who are 50 or over, they can make a catch-up contribution to their SIMPLE IRA of up to $3,000 and $6,500 to their 401(k) for 2021 and 2022.

Understanding a Salary Reduction Contribution

Salary reduction contributions offer employees the opportunity to establish automatic, recurring deductions from their paychecks, which are contributed to an employer-sponsored retirement account. Salary reduction contributions are traditionally pre-tax, meaning the contribution amounts reduce the individual's taxable income in the year of the contribution.

In some cases, contributions can be made with after-tax dollars as in the case of a Roth 401(k), which doesn't provide a tax deduction upfront but the withdrawals or distributions are tax-free in retirement.

Typically, salary reduction contributions are usually a percentage of the employee's compensation or salary. Some plans permit the employee to contribute a specific dollar amount for each pay period throughout the year. 

Salary Reduction Contribution Limits

The Internal Revenue Service (IRS) sets the annual limit on how much money can be contributed to a retirement plan. The annual employee contribution limit for a 401(k), 403(b), and Roth 401(k)—for 2021—is $19,500 per year. This increases to $20,500 in 2022. For both years, a catch-up contribution limit of $6,500 is allowed.

The maximum amount an employee may contribute to a SIMPLE IRA is $13,500 for 2021 (increasing to $14,000 in 2022), with a catch-up contribution limit of $3,000 in both years for those who are 50 or over.

The IRS also offers a salary reduction contribution-based plan called the Salary Reduction Simplified Employee Pension Plan (SARSEP). Such plans are offered by small companies that typically employ fewer than 25 staffers, thus letting employees make pre-tax contributions to their individual retirement accounts (IRAs) through salary reductions.

In accordance with the Small Business Job Protection Act of 1996, no new SARSEPS were allowed to be created after Jan. 1, 1997, but existing plans were allowed to remain in place. Employees can contribute no more than 25% of their income each year or $19,500 in 2021 (increasing to $20,500) in 2022.

Salary Reduction Contribution: After-Tax 

Salary reduction contributions that are made with after-tax dollars must be declared in an employee's tax return as income. If a plan allows for after-tax contributions, such compensation is not excluded from income. Thus, an employee cannot deduct them on their tax return in the tax year of the contribution.

Do 401(k) Plans Reduce Wages?

Technically, yes. 401(k) plans reduce both adjusted gross income (AGI) and modified adjusted gross income (MAGI). The plan allows individuals to defer a part of their salary which qualifies as a tax deduction for that year. This only applies to a traditional 401(k) as it is funded with pre-tax dollars, not to a Roth 401(k), which is funded with after-tax dollars.

What Is the Difference Between SEP and SARSEP?

A SEP IRA is a retirement plan for small businesses that allows an employer to make contributions to an employee's retirement account. The employee is not allowed to make any contribution. A SARSEP is a plan established before 1997 and allows both the employee and employer to make contributions.

What Is the 2021 Roth IRA Contribution Limit?

Individuals can contribute $6,000 to both a traditional IRA and a Roth IRA in 2021 and 2022. If you are aged 50 or older, you can contribute an additional $1,000.

Article Sources
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  1. Internal Revenue Service. "IRS Announces 401(k) Limit Increases to $20,500." Accessed Dec. 8, 2021.

  2. Internal Revenue Service. "Roth Account in Your Retirement Plan." Accessed Dec. 8, 2021.

  3. Internal Revenue Service. "Salary Reduction Simplified Employee Pension Plan (SARSEP)." Accessed Dec. 8, 2021.

  4. Internal Revenue Service. "Retirement Plans FAQs Regarding SARSEPs." Accessed Dec. 8, 2021.

  5. Internal Revenue Service. "Traditional and Roth IRAs." Accessed Dec. 8, 2021.

  6. Internal Revenue Service. "SEP Plan FAQs." Accessed Dec. 8, 2021.

  7. Internal Revenue Service. "Retirement Topics - IRA Contribution Limits." Accessed Dec. 8, 2021.

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