How Will 401(k) Deferral Contributions Affect My Taxes?

A 401(k) deferral contribution is the amount of an employee’s salary that they elect to put in an employer-sponsored retirement savings plan. The portion of the salary that is deferred is not subject to income taxes for the current year. Taxes on deferrals, as well as any earnings that have been generated by investing the funds in the account, are not due until the money is withdrawn. In addition to the salary that the employee elects to defer by placing the tax-advantaged account, another source of contributions can be an employer’s matching amount. To get a handle on how you can save for retirement, consider working with a financial advisor.

How Deferral Contributions Work

A 401(k) is an employer-sponsored account that offers tax advantages to people saving for retirement. Employees can choose to contribute a portion of their current earnings to a 401(k). These deferral contributions, also called elective deferral contributions, are made on a pre-tax basis.

Pre-tax means the money is not subject to income tax at the time it is earned. The money in a 401(k) account can be invested in mutual funds and other investments. Earnings from these investments are also free of taxes until withdrawn.

Another source of contributions to 401(k) accounts comes from employer matches. Employers can opt to match contributions employees make to the plans through deferrals. These matches are typically percentages of the employee’s salary. For instance, an employer may contribute matching amounts equal to up to 3% of the employee’s salary. Employer contributions are also free of current income taxes.

Benefits of Deferral Contributions

The tax-deferral advantages make the 401(k) a popular way of saving for retirement. Since they can start with a larger amount, due to deferring taxes, and earnings also grow tax-deferred, savers who use 401(k) accounts can accumulate savings much faster than those who use after-tax accounts.

The money placed in a 401(k) can later be withdrawn, typically during retirement. If the employee is in a lower tax bracket during retirement, as is often the case, this can result in paying lower taxes overall. The Internal Revenue Service also permits hardship withdrawals before retirement in specific circumstances.

A significant advantage of deferral contributions is that there is no vesting. Employer contributions often are not fully owned by the employee until a certain amount of time, called a vesting period, has gone by. Deferral contributions are fully owned by the employee as soon as the money is earned.

Limits of Deferral Contributions

Deferral contributions have several significant disadvantages as well. The first is that earnings diverted to a 401(k) as a deferral contribution are not available to the employee to spend immediately. Deferring too much salary potentially can create a significant financial hardship if the remaining earnings are insufficient to pay current living expenses.

While tax on employee contributions, employer matches and investment earnings is deferred, it is not eliminated. When the money is later withdrawn, withdrawals are taxed as ordinary income at the tax rate in effect at the time the withdrawal is made. Also, the money in an 401(k) cannot simply be left there to accumulate forever without owing taxes. Tax rules specify that taxable Required minimum distributions from the account begin at a certain point after reaching retirement age.

Limits on contributions cap the amount employees can divert to 401(k)s each year. For tax year 2022, the deferral contribution limit is $20,500 and for tax year 2023 it is set at $22,500.

Retirement plans are designed for funding retirement, and tax rules provide for sizable penalties in most cases if the money is withdrawn before age 59.5. These early withdrawal penalties amount to 10% of the amount of the early withdrawal, plus any income taxes owed at the rate applicable for that tax year.

Individual employees cannot set up their own 401(k) plans, as they can with ordinary taxable investment and savings accounts. Self-employed people can set up their own solo 401(k) plans. Otherwise, the only people who can make deferred contributions to a 401(k) plan are those whose employers offer them, and many employers do not.

Bottom Line

Deferral contributions to a 401(k) are the portions of an employee’s salary that they elect to postpone receiving until later. Income taxes on these funds, as well as any employer matching contributions and investment earnings, are deferred until withdrawn later on, typically in retirement. The tax advantages offered by 401(k) plans encourage retirement savers to use them to defer as much income as they can comfortably afford. Despite contribution caps and other limitations 401(k) deferral contributions are a popular way to save for retirement.

Tips for Retirement Planning

• A financial advisor can help you use a tax-deferred plan such as a 401(k) account to save for retirement.  SmartAsset’s free tool matches you with up to three vetted financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

• To see what you can do with a tax-advantaged retirement savings plan, take a look at SmartAsset’s 401(K) Calculator. This free, online tool will estimate the future value of your 401(k). Just enter your personal details including location, income, age and when you plan to retire and the calculator will do the work for you.

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