What Is an Employer-Sponsored Tax-Sheltered Retirement Plan?

An employer-sponsored tax-sheltered retirement plan is a benefit that allows employees to save for their later years with tax advantages. These plans are designed to encourage long-term savings by providing a structured way to invest a portion of your income. The federal government provides tax incentives for these plans to both employers and employees, making them a popular job perk. Contributions and investment earnings within these accounts are shielded from annual taxes, which helps the funds grow over time.

Common Types of Employer-Sponsored Plans

The most prevalent employer-sponsored retirement plans are defined contribution plans, where the employee and often the employer contribute to an individual account. The ultimate retirement benefit depends on the contributions and investment performance. A 401(k) plan is the most common type offered by private, for-profit companies. For employees of public schools, certain 501(c)(3) non-profit organizations, and religious institutions, the 403(b) plan serves a similar function, while 457(b) plans are often available to state and local government employees.

For smaller businesses and the self-employed, other plan types offer simplified administration. A Simplified Employee Pension (SEP) IRA allows employers to make contributions for themselves and their employees. The Savings Incentive Match Plan for Employees (SIMPLE) IRA is for businesses with 100 or fewer employees and requires employer contributions, either as a match or a fixed amount for all eligible employees. These plans are generally less expensive to set up and maintain than a 401(k).

A more traditional but now less common model is the defined benefit plan, often called a pension. Unlike defined contribution plans, a pension promises a specific, predetermined monthly benefit in retirement. This benefit is calculated using a formula based on salary history and length of service. The employer is responsible for funding the plan and bears the investment risk.

Funding Your Retirement Plan

Employee contributions, known as elective deferrals, are made by dedicating a percentage of your paycheck to your retirement account. Employer contributions are a benefit that can accelerate savings. The most common form is the employer match, where the company contributes based on how much you contribute. A typical matching formula might be 50% of the first 6% of your salary that you contribute. Some employers also make non-elective contributions, such as profit-sharing, to all eligible employees’ accounts.

The Internal Revenue Service (IRS) sets annual limits on contributions. For 2025, the limit for employee elective deferrals to a 401(k), 403(b), or most 457(b) plans is $23,500. The total combined contributions from both the employee and employer cannot exceed $70,000. Individuals age 50 and over can make additional “catch-up” contributions of $7,500.

While your own contributions are always 100% yours, you may have to work for a certain period to gain full ownership of your employer’s contributions. This is determined by a vesting schedule. Common schedules include cliff vesting, where you become 100% vested after a specific period, such as three years, and graded vesting, where your ownership increases incrementally over several years.

Tax Treatment of Contributions and Growth

The “tax-sheltered” nature of these plans is a primary advantage. Traditional contributions are made on a pre-tax basis, meaning the money is deducted from your paycheck before federal and state income taxes are calculated. This action reduces your current taxable income for the year. For example, if you earn $60,000 and contribute $5,000 to a traditional 401(k), you will only be taxed on $55,000 of income for that year.

Some employer plans offer a Roth contribution option. Roth contributions are made with post-tax dollars, meaning you have already paid income tax on the money you contribute. While this provides no immediate tax deduction, the benefit comes in retirement, as qualified withdrawals of your Roth contributions and all associated earnings are completely tax-free.

A feature of both traditional and Roth plans is tax-deferred growth. Any interest, dividends, or capital gains generated by the investments within your account are not subject to taxes each year. This allows your earnings to compound on a larger base, potentially leading to greater growth over the long term.

Accessing Your Retirement Funds

You can begin taking penalty-free withdrawals, known as distributions, once you reach age 59½. The taxation of these distributions depends on the type of contributions you made. Withdrawals from traditional, pre-tax accounts are taxed as ordinary income, while qualified distributions from Roth, post-tax accounts are tax-free. A distribution is typically qualified if the account has been open for at least five years and you are over age 59½.

To ensure that tax-deferred savings are eventually taxed, the IRS mandates Required Minimum Distributions (RMDs). You must begin taking RMDs from traditional retirement accounts by April 1 of the year after you turn age 73. The RMD amount is calculated based on your account balance and life expectancy. Roth 401(k)s are also subject to RMDs, though Roth IRAs are not for the original owner.

Withdrawing funds before age 59½ results in a 10% early withdrawal penalty on top of ordinary income taxes. However, the IRS allows for several penalty exceptions, including for:

• Death, total and permanent disability, or terminal illness
• Withdrawals to pay an IRS levy
• Certain unreimbursed medical expenses exceeding 7.5% of your adjusted gross income
• Qualified birth or adoption expenses up to $5,000

Managing Your Plan When Changing Jobs

When you leave an employer, you must decide what to do with the funds in your retirement account. Handling this transition carefully is important to avoid negative tax consequences. You have several options:

• Leave the money in your former employer’s plan, provided the plan allows it and your vested balance meets a minimum threshold. This can be a simple choice if you are satisfied with the plan’s investment options and fees, though you will no longer be able to make new contributions.
• Roll the funds over into an Individual Retirement Arrangement (IRA). A direct rollover is the simplest method and avoids tax withholding. An IRA often provides a wider range of investment choices than an employer-sponsored plan.
• Roll your old account directly into your new employer’s plan, if it accepts rollovers. This consolidates your retirement savings into a single account, making it easier to manage your overall portfolio.
• Cash out the account. This is considered a distribution and will be subject to ordinary income tax. If you are under age 59½, you will also face a 10% early withdrawal penalty, significantly reducing your retirement savings.