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.

Understanding Salary Reduction Contributions

Salary reduction contributions offer employees the opportunity to establish automatic, recurring deductions from their paychecks, which is 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 2020 and 2021 — is $19,500 per year. For those who are aged 50 or older, a catch-up contribution of $6,500 can also be added for both 2020 and 2021. The maximum amount an employee may contribute to a SIMPLE IRA is $13,500 for 2020 and 2021, 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 January 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 2020 and 2021.

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.