The 401(k) plan is a popular type of retirement plan offered by many employers. 401(k) plans are salary deferral arrangements where employees choose to set aside (defer) a certain portion of their paychecks into retirement plan accounts. If you participate in a 401(k) plan, the amount of money available to you in retirement from the plan will depend on how long you participate in the plan, how much is invested by you and your employer, and how well your investments do over the years. Other types of employer-sponsored salary deferral plans are 403(b) plans, 457 plans, SIMPLE plans and salary reduction SEP (SAR-SEP) plans. All of these plans have separate and distinct rules and must be looked at individually, but the salary deferral feature is common to all. Although salary deferral plans are primarily funded by employee salary deferrals, many employers contribute to each employee’s account by giving either a profit sharing contribution or by matching a certain percentage of the employee’s deferrals.
Many people mistakenly believe they cannot afford to reduce their paychecks by the amount they would like to contribute to their 401(k) plans. But the following example illustrates that the reduction in take-home pay is not as big as some might think. Assume you defer $100 into a 401(k) plan each month, and you pay income taxes at a rate of 15 percent. The $100 you put in your 401(k) plan is not included in your taxable income until you take it out of the plan. If you don’t put that $100 in your 401(k) plan – you will pay $15 tax on that $100 and take home only $85. Thus, your $100 retirement plan contribution actually only reduces your take-home pay by $85. This is like buying your retirement at a discount.