Salary reduction plan

Salary reduction plan

A plan allowing employees to contribute pre-tax income to a tax-deferred retirement plan.

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salary reduction plan

A retirement plan that permits an employee to set aside a portion of salary in a tax-deferred investment account selected by the employer. Contributions made to the account and income earned by the contributions are sheltered from taxes until the funds are withdrawn. Also called 401(k) plan.

Case Study Salary reduction plans offer substantial tax benefits, yet at the same time they can place employee contributions at considerable risk depending on what type of investments are used to fund the plans. Especially risky are plans that invest all or most of the contributions in the employer's common stock. Consider the example of energy conglomerate Enron Corporation, whose stock tumbled nearly 99% to 60¢ per share in the 12 months ending November 2001. At of the end of 2000 approximately half of Enron's $2.1 billion 401(k) plan was invested in Enron common stock. Enron's policy was to match employee contributions at 50¢ on the dollar, for up to 6% of an employee's salary. Like many major corporations, Enron made its contributions to the firm's plan in company stock. Employees were permitted to select alternative investments, but many chose to use Enron shares to fund their contributions. As Enron shares plummeted many employees of the company saw virtually the entire value of their individual 401(k) plans evaporate at the same time as they faced the possibility of losing their jobs in a company that filed for bankruptcy.

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Salary reduction plan. A salary reduction plan is a type of employer-sponsored retirement savings plan. Typical examples are traditional 401(k)s, 403(b)s, 457s, and SIMPLE IRAs.

A salary reduction plan allows you, as an employee, to contribute some of your current income to a retirement account in your name and to accumulate tax-deferred earnings on those contributions. In most plans, you contribute pretax income, which reduces your current income tax, and you pay tax at withdrawal at your regular rate.

Your employer may match some of or all your contribution according to a formula that applies on an equal basis to all participating employees. All salary reduction plans have an annual contribution cap that's set by Congress and allow annual catch-up contributions for participants 50 and older.

With Roth 401(k) and similar plans, you contribute after-tax income but qualify for tax-free withdrawals if you are older than 59 1/2 and your account has been open at least five years.