If the defined contribution plan your employer offers is a salary deferral plan, you can put part of your earnings into a retirement savings account. Your employer may contribute to your account as well. The best-known salary deferral plans are 401(k) plans.
Salary deferral plans are generally self-directed. This means you are responsible for deciding how to invest the money that accumulates in your account. Usually you must choose among a list of investments the plan offers. The advantage of self-direction is that you can select investments that you believe will help you achieve your long-term goals. But, of course, it also means added responsibility for choosing wisely.
When you participate in a traditional 401(k) plan, the taxable salary that your employer reports to the IRS is reduced by the amount that you defer to your account. This means income taxes on that money are postponed until you withdraw from your account, usually after you retire.
If you participate in a Roth 401(k), though, the amount you defer doesn't reduce your taxable income or your current income taxes. But when you withdraw after you retire, the amounts you take out are tax-free, provided you're at least 59½ and your account has been open at least five years.
| The Facts of Deferral A CODA, short for cash or deferral arrangement, describes a qualified plan that gives you the option of either taking salary as it’s earned, or contributing it to a qualified plan, such as a 401(k). If you contribute your money to a qualified plan, you defer its use until later in retirement, and your contributions grow tax deferred. |
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