A salary reduction contribution is a contribution made to a retirement savings plan that is generally a percentage of an employee's compensation. Also known as an elective deferral contribution, a salary reduction contribution in some plans may also take the form of a specific dollar amount contributed to an employer-sponsored retirement savings plan, such as a 401(k), 403(b) or a SIMPLE IRA. In these cases, the saver defers pays taxes on their contributions until they take distributions (at the 35% rate), allowing the sum they have saved to grow tax-deferred.
With a salary reduction contribution an employee can set up automatic, recurring deductions from their paycheck to be put into a retirement savings account. Such salary reduction contributions tend to be pre-tax but may also be after-tax. Salary reduction contributions may also be made to Roth IRAs and into employee-sponsored retirement accounts as a part of catch-up contributions.
In the United States, the Internal Revenue Service (IRS) sets the rules for salary reduction or elective deferral contributions.
According to the IRS, salary reduction contributions are "pre-tax employee contributions that are a generally a percentage of the employee's compensation. Some plans permit the employee to contribute a specific dollar amount each pay period. 401(k), 403(b) or SIMPLE IRA plans
The IRS imposes limits on salary reduction contributions. For example, the total amount an employee may contribute from their paycheck to a SIMPLE IRA cannot surpass $12,500 (in 2018). If that employee also participates in another employer-sponsored retirement savings plan the total amount of salary reduction contributions, they can make cannot exceed a total of $18,500 (as of 2018). For more, see SIMPLE IRA Contribution Limits from the IRS.
The IRS also offers a salary reduction contribution-based plan called the SARSEP, or Salary Reduction Simplified Employee Pension Plan. Such plans are offered by small companies — typically those with fewer than 25 employees — that allows employees to make pretax contributions to their Individual Retirement Accounts (IRAs) through salary reduction. For more, see the IRS's SARSEP informational page.
Salary reduction contributions that are made with after-tax dollars must be included in an employee's tax return as income. If a plan allows for after-tax contributions, such compensation is not excluded from income. Thusly, an employee cannot deduct them on their tax return.