What Is Salary Deferral in a 401(k)?

Saving for retirement is a significant financial goal for many individuals, and employer-sponsored plans offer an effective way to accumulate funds for the future. Among these options, the 401(k) plan stands out as a widely adopted savings vehicle. These plans allow individuals to set aside a portion of their income specifically for retirement, often benefiting from tax advantages. Understanding how contributions are made to these accounts is a fundamental step in maximizing their potential.

Defining Salary Deferral

Salary deferral in a 401(k) plan refers to an employee’s voluntary decision to allocate a portion of their gross wages directly into their retirement account. This process occurs before income taxes are calculated and withheld from the employee’s paycheck. Essentially, the employee instructs their employer to send a specified amount or percentage of their pay to the 401(k) plan instead of receiving it as taxable income. This direct contribution reduces the employee’s current taxable income, which can lead to a lower tax liability, and the funds are then invested within the 401(k) account, with earnings growing on a tax-deferred basis until retirement.

Employee Deferral Choices and Limits

Employees participating in a 401(k) plan have two primary methods for salary deferrals: pre-tax and Roth contributions. Pre-tax contributions reduce current taxable income because they are not subject to federal income tax until withdrawal in retirement, providing an immediate tax benefit. In contrast, Roth contributions are made with after-tax dollars, so they do not reduce current taxable income. However, qualified withdrawals in retirement, including both contributions and earnings, are entirely tax-free.

The Internal Revenue Service (IRS) sets annual limits on the amount an employee can defer to a 401(k) plan. For 2025, the maximum employee contribution, known as the elective deferral limit, is $23,500. This limit applies to the total amount an individual contributes across all 401(k) plans during the year, not per plan. Individuals aged 50 and over are eligible to make additional “catch-up” contributions, as permitted by law. For 2025, the standard catch-up contribution limit is $7,500, allowing those aged 50 and older to contribute up to $31,000 in total.

Employer Contributions to a 401(k)

Beyond employee salary deferrals, many 401(k) plans include employer contributions, a distinct funding component. These contributions are made by the employer directly to the employee’s retirement account and do not come from the employee’s wages. Common types include matching contributions, where the employer contributes based on employee deferrals, and profit-sharing contributions, which are discretionary payments.

Employer contributions enhance an employee’s retirement savings but are typically subject to vesting schedules. Vesting refers to the process by which an employee gains full non-forfeitable ownership of the employer’s contributions. A common vesting schedule might require an employee to work for a certain number of years, such as three to five years, to become fully vested, or it could be a graded schedule where a percentage vests each year. If an employee leaves their job before being fully vested, they may forfeit a portion or all of the unvested employer contributions.