A Salary Deferral Arrangement is an arrangement whereby a plan participant can choose to receive their pay in cash or to have a portion of their pay contributed to their employer’s qualified 401(k) plan. In electing to defer a portion of your pay, Federal Taxes and certain State’s taxes on the deferred amounts (and earnings on those amounts) are deferred until such time as you actually receive a cash distribution of your account balance. However, these taxes can be further deferred by rolling over the distributed account balance to an IRA or to another qualified retirement plan in which you have become a participant, rather than taking the distribution in cash.
There are many advantages to a Salary Deferral Arrangement under a 401(k) plan. First is the deferral of taxes. Distributions from the most common qualified retirement plans are taxed as ordinary income, so deferring taxes until you retire may mean you are in a lower tax bracket than at the time you actually deferred the income. This means that the percent of the total amount you pay as tax may be lower.
Second is the compounding effect of interest on the growth of your retirement plan account. With Uncle Sam waiting to take their bite until you actually receive a cash distribution from your account balance, more of your money is going to work for you rather than to the tax coffers. This means, theoretically, a larger account balance at retirement.
Third is the dollar cost averaging effect of investing. With a steady and consistent amount being invested over time, the amount of shares you buy will depend on the price per share of your chosen investment. When the share price is low in a particular investment, your salary deferral amount buys more shares. When the share price is high, your salary deferral amount buys fewer shares. Theoretically, over time your average share price will be lower than if you would have invested a large amount several times.