1. It Reduces Your Taxable Income
Salary-deferral contributions to your employer sponsored plan are usually made on a tax-deferred basis. This means that your taxable income for the year is reduced by the amount you contribute to the plan. For example, say that your tax filing status is "single", your taxable income for the year is $31,000, and the amount of federal income tax you owe is about $4,232 (based on 2010 rates). If you make a pretax salary-deferral contribution of $2,000 to your 401(k) account your taxable income will be reduced to $29,000, and the amount of taxes you owe will be $3,932, resulting in a tax reduction of $300.
Of course, an individual's tax reduction depends on the amount deferred and the tax bracket within which his or her taxable income falls; therefore, the tax savings are not the same for everyone. In the example above, you will eventually need to withdraw the $2,000 you deferred. But if you refrain from withdrawing it until you retire, when you are likely in a lower tax bracket, you will pay less tax on the $2,000 than you would've paid had you not chosen to defer it to your retirement account.
Note: Salary deferral contributions to non-IRA based plans can also be made on an after-tax basis. In such cases, these contributions do not reduce taxable income.
2. It Provides Tax Deferred Growth and Allows You to Defer Taxes
Another benefit of saving with a tax-deferred retirement plan is that the earnings on investments are also tax-deferred. This means that you will not pay taxes on your earnings, regardless of their value, until you make a withdrawal from the plan. You therefore have some control over when you pay taxes on those earnings, which in turn could affect how much tax you pay.
For instance, you can choose to make withdrawals in years when your income is lower, which may mean, again, that you are in a lower tax bracket. On the other hand, if you chose to invest the amount in an account that is not tax-deferred, you would owe taxes on the earnings the year the earnings are accrued. (Usually, an individual is allowed to make withdrawals from a qualified plan only after meeting certain requirements, as defined under the plan. In addition, RMD rules will apply, which will dictate some withdrawal options.)
John's taxable income for the year is $31,000, and he wants to save $2,000 towards his retirement. John is deciding whether to deposit the amount to a certificate of deposit (CD) with post-tax assets or to make a pre-tax salary deferral contribution to his 401(k) account.
3. You Get Free Money
Many employers include matching-contribution provisions in 401(k), SIMPLE IRA and other salary deferral feature plans. If you are a participant in such a plan and you are not making salary-deferral contributions, you could be losing the benefits offered by your employer. At minimum, you should consider making salary deferrals up to the maximum amount your employer will match. (Not taking taking you employer's offer to match contributions is just plain dumb.
Contributions from your employer accrue earnings on a tax-deferred basis and are not taxed until you withdraw the amount from your retirement account. Let's look at another example examining John's situation:
John works for ABC Company, which agrees to make a matching contribution of 50 cents on every dollar, up to 6% of each employee's compensation. John's compensation is $31,000 per year, of which 6% is $1,860. If John contributes $2,000 from his paychecks throughout the year, John will receive an additional $1,000 contribution to his 401(k) account from ABC Company (50% of $2,000). If John wants to receive the maximum 6% of his compensation ($1,860) that ABC would contribute to his 401(k) account, John must defer $3,720.
Had John chosen not to make any salary-deferral contributions, he would lose not only the opportunity to reduce his taxable income and the benefit of tax-deferred growth, but also the matching contribution from his employer.