Is a 401(k) Considered Deferred Compensation?
- According to IRS publication 424, a 401k plan is a qualified type of deferred-compensation plan that employees can elect to participate in. A deferred compensation plan is one in which workers can elect to defer part of their pay by putting it toward their retirement. Participation is voluntary, and workers can choose to suspend contributions at any time. Since compensation is "deferred," participants do not immediately pay taxes on the income. Instead, they pay taxes on their contributions and any investment returns, as ordinary income, when they begin receiving qualified distributions. The 401k plan is offered by private employers, while public employees and employees of nonprofits can participate in a 403b -- also a form of deferred compensation plan -- with similar contribution limits and restrictions.
- At the time of publication, workers can defer up to $16,500 of their earned income annually into a 401k. Workers who are 50 years of age or older can defer even more by adding $5,500 extra to their plans, for a total compensation deferral of $22,000. Many employers offer a match on a portion of contributions. For instance, the employer might contribute 50 cents for every dollar the worker kicks in, up to 6 percent of earnings. Those employer contributions do not count toward the $16,500 or $22,000 annual limit.
- When you receive your W-2 form for the year, that form will reflect the amount you contributed to your employer's 401k plan. You can easily see the impact of this deferred compensation program by comparing your federal taxable wages to your Social Security and Medicare wages. The money you contribute to a 401k plan is not subject to federal income taxes, but it is still subject to Social Security and Medicare taxes.
- If you are considering getting started with your 401k plan, or adding to your current contribution, it makes sense to do some advance tax planning. Running the numbers at various contribution limits can help you determine just how much you can save on taxes by participating in your employer's 401k plan or boosting the amount you defer with the plan. If your employer offers a match, you may want to consider contributing at least the amount that would qualify for a matching contribution.
