To encourage retirement savings, the Internal Revenue Service offers special tax incentives if you use a qualified plan. Tax-deferred pension plans include 401(k)s, 403(b)s, 457(b)s and savings incentive match plans for employees' individual retirement accounts. However, there are restrictions on how much you can contribute and when you can access the money.
Income Tax-Exempt Contributions
Your contributions to a tax-deferred pension plan escape being taxed in the year you make the contributions. However, your contributions aren't exempt from payroll taxes: Social Security tax and Medicare tax still apply. For example, if your salary is $65,000 but you contribute $7,500 to your tax-deferred pension, you only pay income taxes on the first $57,500 of your salary, but you still pay Social Security and Medicare taxes on the entire $65,000.
As of 2013, you're not allowed to contribute more than $17,500 to all of your pensions combined, and some plans have lower limits. For example, you can't contribute more than $12,000 per year to a SIMPLE IRA. In addition, your contributions plus your employers' contributions can't exceed $51,000. An exception is allowed for contributions to a 457(b) plan. Even though you can't contribute more than $17,500 to a 457(b), the limit is separate from the other tax-deferred pension plans, so you could put $17,500 into a 457(b) plan and $17,500 into a 401(k) plan in the same year.
While the money stays in your tax-deferred pension, you don't pay any taxes at all on the earnings, which results in the money growing faster because none of your profits get shared with Uncle Sam. For example, say your pension grows by 8 percent and you fall in the 28 percent tax bracket. If the money weren't growing in a tax-deferred account, you would have to share 28 percent of the growth with the government. So, instead of growing by 8 percent, after taxes the pension would only be growing by 5.76 percent.
Distributions from your tax-deferred pensions are taxed as ordinary income, even if you've been investing the money. For example, even if you held stocks for more than a year before cashing out, your distributions still won't qualify as long-term capital gains. Plus, you're not allowed to take penalty-free distributions from your tax-deferred pension until you reach age 59 1/2. Earlier distributions are hit with a 10 percent additional tax penalty, unless you qualify for an exception. Uncle Sam lets you off the hook for the penalty if you're permanently disabled, have medical expenses exceeding 10 percent of your adjusted gross income, the IRS levies your account, you take a qualified reservist distribution or you leave your job after turning 55.
- Internal Revenue Service: Topic 424 -- 401(k) Plans
- Internal Revenue Service: IRS Annouces 2013 Pension Plan Limits
- CNN Money: How Much Can I Contribute?
- CNN Money: Retiring? Make the Best Use of Tax-Deferred Plans
- Internal Revenue Service: Topic 558 -- Additional Tax on Early Distributions from Retirement Plans, Other Than IRAs
- Internal Revenue Service: Topic 502 -- Medical and Dental Expenses
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."