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Updated December 12, 2023 Reviewed by Reviewed by David KindnessDavid Kindness is a Certified Public Accountant (CPA) and an expert in the fields of financial accounting, corporate and individual tax planning and preparation, and investing and retirement planning. David has helped thousands of clients improve their accounting and financial systems, create budgets, and minimize their taxes.
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By participating in your employer-sponsored retirement plan, you save and ensure sufficient income for your retirement. However, many employees choose not to sign up and may be unaware of the benefits of these plans. We found three advantages of making salary-deferral contributions to employer-sponsored plans, such as 401(k)s and 403(b)s.
Contributions to your employer-sponsored plan are commonly tax-deferred, where your annual taxable income is reduced by the amount you contribute. However, distributions at retirement are taxed, but you'll likely be in a lower tax bracket as a retiree.
If your tax filing status is "single," your taxable income for the year is $31,000, and you contribute $2,000 to your 401(k) account, your taxable income will be reduced to $29,000. For 2024, the annual individual contribution limit, set by the Internal Revenue Service (IRS), to a 401(k) plan is $23,000. If you are 50 or older, you can make an additional catch-up contribution of $7,500.
Contributions can also be made to designated Roth accounts on an after-tax basis. These contributions do not reduce your taxable income.
When saving with a tax-deferred retirement plan, investment earnings are also tax-deferred. You will not pay taxes on your interest or gains over the years, regardless of their value, until you withdraw from the plan at retirement.
Many employers include matching-contribution provisions in their company plans. If you do not participate and are not making salary-deferral contributions, you lose the benefits offered by your employer. Consider contributing up to the maximum amount your employer will match, or you may miss out on "free money." The matching funds also accrue earnings on a tax-deferred basis and are not taxed until you withdraw the amount from your retirement account.
John works for ABC Company, with 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, and 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.
Many employer plans require an employee to complete a certain number of years or vesting before the employer contributes matching funds to a 401(k).
When you retire, consider other income sources, such as Social Security, when deciding how much you want to withdraw from your retirement savings. Your total income will determine your overall tax rate for that year.
To withdraw from a qualified plan, a participant must be over age 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.
After age 73, you must begin distributing funds annually from a 401(k) as required minimum distributions (RMDs). The amount of the RMD is calculated by the IRS, based in part on your total retirement savings.
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.
An IRA doesn't have an employer-matching benefit, but you receive a tax deduction in the years you contribute money. Also, any earnings grow tax-free, and you're not taxed on the money until you withdraw it in retirement. Contribution limits are lower for IRAs versus 401(k)s. For 2024, it's $7,000, and those over 50 can contribute an extra $1,000 as a catch-up contribution.
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.
The two main types of employer-sponsored retirement plans are defined-benefit and defined contribution. Defined-benefit plans are traditionally pension plans, where an individual receives a guaranteed monthly payment. A defined-contribution plan like a 401(k) does not offer a guaranteed monthly payment, and the account value can vary depending on market fluctuations.
401(k) and 403(b) plans are both defined-contribution retirement plans. The primary difference is that a 401(k) plan is offered to employees in the private sector working for for-profit companies, and a 403(b) plan is for employees in non-profit organizations and the government.
The contribution limit for a 401(k) plan is $23,000 in 2024. An additional $7,500 is allowed if you are aged 50 or older.
Employer-sponsored retirement plans are a way to save for retirement and come with many benefits. The plans reduce your taxable income, investments grow tax-deferred, and you can get "free money" through employer matching contributions.
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The thrift savings plan (TSP) is a retirement investment program open only to federal employees and members of the uniformed services.
The CSRS provided the retirement, disability, and survivor benefits for most U.S. civilian service employees working for the federal government.
The life expectancy method calculates IRA payments by dividing the balance of a retirement account by the policyholder’s anticipated length of life.
An after-tax contribution is a deposit into a retirement account of money that has been taxed in the year in which it was paid into the account.
A 401(a) plan is an employer-sponsored money-purchase retirement plan funded with contributions from the employee, the employer, or both.
Rule 72(t), issued by the Internal Revenue Service (IRS), allows for penalty-free withdrawals from an IRA account and other certain tax-advantaged accounts.
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