Types of Salary-Reduction Plans

There are several types of salary-reduction plans, which are categorized according to the type of company that installs the plan and whether the plan uses before-tax or after-tax dollars for funding.

 

401(k) plans:A 401(k) plan is a retirement plan set up by a private company. In a 401(k) plan, you contribute a percentage of your salary up to a specified amount ($15,500 in 2007 or $20,500 if you are over age 50), and the money grows in a tax-deferred account until you retire. Your employer may or may not contribute a matching amount (free money). Because this money is tax deferred, you do not have to pay taxes on the money until you withdraw it after you reach age fifty-nine and a half.

Roth 401(k) plans:In a Roth 401(k) plan, you contribute a percentage of your salary up to a specified amount ($15,500 in 2007 or $20,500 if you are over age 50). Roth 401(k) plans are unique in that you contribute to the fund using after-tax dollars, or money on which you have already paid taxes. These plans are beneficial because the money grows until you retire, and you never need to pay taxes on the earnings and capital gains again if you withdraw it after age fifty-nine and a half.

403(b) plans:A 403(b) plan is basically the same as a 401(k) plan; however, 403(b) plans are specifically designed for employees of nonprofit, tax-exempt companies and institutions (for example, schools). The maximum contribution amount is the same as for 401(k) plans: $15,500 in 2007.

Roth 403(b) plans:A Roth 403(b) plan is basically the same as a Roth 401(k) plan; however, it is specifically designed for employees of nonprofit, tax-exempt companies and institutions (for example, schools). Contributions are made with after-tax dollars, and individuals are not required to pay taxes on withdrawals after individuals reach age fifty-five. The maximum contribution amount is the same as for 403(b) plans: $15,500 in 2007.

457 Plans:A 457 plan is basically the same as a 401(k) plan, but it is specifically designed for state and municipal workers. The maximum contribution amount is the same as for 401(k) plans: $15,500 in 2007.

 

 Matching Plans

In a matching plan, the employer matches all or a percentage of the contributions you make to your retirement fund. Approximately 89 percent of all 401(k) plans include a matching component. Table 5 shows a sample matching schedule: actual matching plans will vary.

Table 5 Employer Matching Schedule in a Hypothetical 401(k) Plan

Employee Contribution	Employer Contribution	Total Contribution
1.0%	1.0%	2.0%
2.0%	2.0%	4.0%
3.0%	3.0%	6.0%
4.0%	3.5%	7.5%
5.0–21.0%	4.0%	9.0–25.0%

Note that with a Roth 401(k) or Roth 403(b) plan, the employer contribution is made on a before-tax basis and not an after-tax basis. Funds that the employer provides as a match are held in a separate tax-deferred account; taxes must still be paid on the matched amount at retirement.