Salary deferral means taking some of your income and putting it aside for later. Literally you are deferring your salary for later use, usually for use at age 59 ½ or thereafter.
The term salary deferral is most commonly used when describing how a 401k plan works. A 401k plan is a retirement plan that may be offered by your employer, or if you are self-employed you can set up your own 401k plan.
Learn more: 4 Best Retirement Plans for Self-Employeds
A 401k plan is regulated by tax code and has rules that must be followed. These rules allow you to defer some of your salary for later use by putting it into the plan. When you do this you won’t pay income taxes on the deferred amount in the current year. These are called tax-deferred contributions (some plans also allow you to make after-tax contributions).
Example of Tax Deferral with Salary Deferral
Let’ say you defer $100 a month of your salary into an employer retirement plan. That’s $1,200 over a year.
Assume you are in the 25% tax bracket. Normally you would pay $300 of tax on that $1,200 of earnings. When you put it into a tax-deferred plan, you do not pay taxes on it. The full $1,200 goes into the plan, and is not counted as taxable income that year. You will pay taxes when you withdraw the money and there are restrictions as to when you can withdraw this money. Penalty taxes apply if you withdraw it before you reach age 59 ½.
Learn more: How Tax Deferred Savings Work
How Much Salary Can You Defer?
There is a limit to how much of your salary you can defer into the plan. Different salary deferral limits apply depending on the type of plan.
Why Should You Defer Salary?
The sooner you start saving money for your future, the easier it will be to reach a minimum level of financial security. No matter how little, or how much you make, you should always live on less than you make, and find a way to save some of your earnings.
Putting aside money right from your paycheck through salary deferral contributions is an easy and convenient way to save. In addition, sometimes your employer will offer you a matching contribution to your retirement plan. This means if you defer some of your salary, they contribute some of their own money to match.
The higher your tax bracket, the more it can make sense to make pre-tax salary deferral contributions. If you are in a low tax bracket, or pay no tax because you have many deductions, than pre-tax salary deferrals may not make as much sense.
For low tax bracket workers, and for younger workers, ask your employer if they offer post-tax salary deferral contributions to a ROTH 401k.
Learn more: Pre Tax Verses After Tax Investments
When Is It Not a Good Idea to Defer Salary?
Most plans that allow you the ability to make salary deferral contributions also have restrictions on when and how you can access your money. Salary deferral contributions are a good way to start accumulating a nest egg because the money is restricted from your daily use but you also need to have savings that is not restricted.
If you do not have three to six month savings in a bank savings account or other easily accessible account, you may want to hold off on salary deferral contributions and work on building up regular savings, which is sometimes referred to as an emergency fund.
Learn more: Top Ten Reasons to Have an Emergency Fund