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.

In these cases, the saver defers paying taxes on their contributions until they take distributions, thereby allowing the sum they have saved to grow in a tax-deferred manner.

Key Takeaways

  • Salary reduction contributions are monies earmarked for retirement savings plans, usually consisting of a fixed percentage of an employee's paycheck. 
  • Salary reduction contributions may apply to 401(k), 403(b), or SIMPLE IRA plans. 
  • In most cases, investors face tax liabilities on their contributions only after they begin taking distributions upon retirement.
  • The IRS imposes limits on salary reduction contributions. For SIMPLE IRAs, the contributions may not exceed $12,500. 
  • Salary reduction contributions can also be channeled toward Roth IRAs and employee-sponsored retirement accounts as a part of catch-up contributions. 

Understanding Salary Reduction Contributions

Salary reduction contributions offer employees the opportunity to establish automatic, recurring deductions from their paychecks and funnel those monies into retirement savings accounts. Although such salary reduction contributions are traditionally pre-tax, in some cases, they may be after-tax. Salary reduction contributions may also be funneled into Roth IRAs and employee-sponsored retirement accounts as a part of catch-up contributions

Salary Reduction Contribution: IRS Definition

According to the IRS, salary reduction contributions are pre-tax employee contributions that are generally a percentage of the employee's compensation. Some plans permit the employee to contribute a specific dollar amount for each pay period throughout the year. Notably, 401(k), 403(b), or SIMPLE IRA plans may permit elective deferral contributions above and beyond the basic limit on elective deferrals.

Salary Reduction Contribution Limits

The IRS imposes limits on salary reduction contributions. For example, as of 2018, the total amount an employee may contribute from their paycheck to a SIMPLE IRA cannot surpass $12,500. If that employee also participates in another employer-sponsored retirement savings plan, his or her total salary reduction contributions cannot exceed $18,500.

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 that typically employ fewer than 25 staffers, thus letting employees make pre-tax contributions to their Individual Retirement Accounts (IRAs) through salary reductions. The IRS provides extensive guidance on SARSEP Plans.

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.