A Not So Brief History of Salary Deferrals in Retirement Plans
By Mike Rahn, CISP
For those whose careers began during the current heyday of 401(k) plans, the option to save a significant portion of income on a tax-advantaged basis in an employer-sponsored retirement plan is more or less taken for granted. In fact, employee “salary deferrals”—contributions of salary or wages to a plan, versus receiving in cash—now make up the majority of annual contributions to defined contribution plans.
But there was a time when this option did not exist, a time when most benefits received through defined contribution plans came from one’s employer. Such benefits typically were received as profit sharing contributions, or as mandated employer contributions in a money purchase or target benefit pension plan.
As for defined benefit pension plans, over the years many have required employees to make contributions from their own salary or wages, but these generally have been made as “after-tax” amounts, and thus do not reduce an employee’s income taxation for years in which such contributions are made.
403(b) Deferrals Preceded 401(k)
It may come as a surprise that the first employee salary deferral options were those Congress made available starting in 1958—under new Internal Revenue Code Section 403(b)—for employees of nonprofit organizations. Soon after, in 1961, this option was made available to public school employees. It is generally believed that this was motivated by the fact that employees of nonprofit, charitable, and taxpayer-funded entities typically did not have generous retirement plans available to them compared to employees of corporate entities.
But the event that ushered in the modern era of salary deferral-type plans was the Revenue Act of 1978. This legislation added Section 401(k) to the Internal Revenue Code, a provision initially seen as a way for private sector employees to defer, or delay, the taxation of bonuses or stock options received from their employers.
The Revenue Act of 1978 also enabled employees to make salary deferrals into governmental 457(b) plans, and created simplified employee pension (SEP) plans, including a salary deferral version known as the SAR-SEP plan, but this option was only available to employers with no more than 25 eligible employees.
Benefits consultant Ted Benna is widely credited with first recognizing that the 1978 statutory changes allowed private sector employees to delay income taxation by contributing amounts that would otherwise be received as everyday salary, or wages, not just bonuses or stock options. Subsequent Treasury regulations in 1981 confirmed this, ushering in a revolution in the design and structure of employer-sponsored retirement plans.
No longer would rank and file employees who wished to save for retirement be limited only to the generosity of their employers. On the other hand, employers soon recognized that this new retirement plan landscape allowed them to shift some—or much—of the retirement benefit burden from their sponsoring businesses to employees. This was particularly true of corporate defined benefit pension plans, which began a steady decline, and are now a minority among private sector plans.
Small Business Job Protection Act of 1996 (SBA-96)
A true watershed event for deferral-type retirement plans was the enactment of the Small Business Job Protection Act of 1996 (SBA-96).
A 401(k) Testing Safe Harbor
SBA-96 created a “safe harbor” design for 401(k)-type plans. Before SBA-96, 401(k) plan nondiscrimination testing could limit the salary deferrals of a plan’s so-called “highly-compensated” employees (HCEs), and thus potentially their employer matching contributions as well. This nondiscrimination testing restricted an HCE’s deferral rate—as a percent of compensation—to a rate only minimally greater than the average deferral rate of the plan’s “nonHCEs.”
In practical effect, if a plan’s nonHCEs deferred relatively little as a percent of their salary, then the rate at which a plan’s HCEs could make salary deferrals would be limited, too. SBA-96’s new testing “safe harbor” meant that with a minimal employer contribution commitment—a 4 percent match, or 3 percent nonelective contribution—a plan’s HCEs could make salary deferrals up to the maximum statutory amount without nondiscrimination testing holding them back.
Some questioned whether this change represented good public policy, viewing the safe harbor as potentially reducing a plan-sponsoring employer’s incentive to provide investment education, and to encourage its workers to save for retirement.
SIMPLE Retirement Plans
SBA-96 also created savings incentive match plan for employees of small employers (SIMPLE) retirement plans, in both IRA-based and 401(k)-based versions. Both have salary deferral levels that are lower than those available for regular 401(k), 403(b), SAR-SEP, and governmental 457(b) plans, and require a minimal employer match or nonelective contribution.
The SIMPLE IRA plan has become a very popular, less complex entry-level option for employers with no previous retirement plan. The SIMPLE 401(k), on the other hand, has clearly lost the popularity contest, likely due to its lower contribution potential than regular 401(k) plans, with little reduction in administrative complexity and limited access to employee contributions.
A casualty of SBA-96, apparently linked to the creation of SIMPLE plans, was elimination of SAR-SEPs as a plan option, beginning in 1997. Plans in place in 1996, or before, are grandfathered, and can continue to be maintained, add new employees, change service providers, amend for future regulatory changes, etc.
Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA)
The Economic Growth and Tax Relief Reconciliation Act of 2001, known by its acronym “EGTRRA,” added multiple provisions with salary deferral elements to the Internal Revenue Code, further adding to the appeal of deferral-type retirement plans.
Annual Addition and Employer Deduction Limit Changes Boost Individual 401(k)s
Before EGTRRA, the maximum defined contribution plan benefit that an employee (or owner-employee) could receive each year under all plans of that employer—the “annual additions” limit—was 25 percent of compensation. Or—if less—a set dollar amount, which was $35,000 when EGTRRA was enacted. Only $150,000 of compensation—the “compensation cap”—could be considered when allocating employer contributions, such as matching or profit-sharing contributions.
EGTRRA raised the percent-of-compensation element of the annual additions limit from 25 percent to 100 percent of compensation. As a result, the combination of employee salary deferrals and employer contributions could—from an annual additions standpoint—be as high as 100 percent of an individual’s compensation, as long as the dollar limit for the year was not exceeded.
EGTRRA did not change the maximum employer tax deduction for contributions to a retirement plan, which remained at 25 percent employee of compensation. Before EGTRRA, however, employee salary deferrals were counted together with actual employer contributions toward this limitation. EGTRRA ended this requirement.
As a result, as long as employer matching, profit sharing, and all mandated or discretionary employer contributions do not exceed 25 percent of employee compensation, and no employee-specific contribution limit is exceeded, an employee’s maximum contribution could be greater than ever before; theoretically, as much as 100 percent of his compensation.
This has proven to have significant appeal and to offer enhanced retirement saving opportunity for many who have self-employment income, perhaps in addition to being a common-law employee of another firm.
EGTRRA Raises Deferral Limit by 50 Percent
Annual salary deferral limits had been rising slowly but steadily over the years before EGTRRA, as a result of annual indexing for cost-of-living adjustments. EGTRRA gave 401(k), 403(b), and SAR-SEP plans a major one-time boost by increasing the annual deferral limit by 50 percent, from $7,000 to $10,500—effective for 2002—with continued standard indexing for years thereafter.
Catch-Up Deferral Contributions
A consistent long-term belief in the “retirement space” is that too many American workers are saving too little to assure a secure retirement. Perhaps in recognition of this, EGTRRA drafters included a provision for additional or “catch-up” salary deferrals for those age 50 or older. This began in 2002, and applies to 401(k), 403(b), governmental 457(b), SAR-SEP, and SIMPLE retirement plans. Amounts have indexed from their 2002 levels since that time.
Importantly, catch-up deferrals are disregarded for nondiscrimination testing in those plans that require such testing—whether they are made by HCEs or non-HCEs—and therefore cannot contribute to a 401(k) plan failing such testing.
EGTRRA Adds Roth Deferral Option
Salary deferrals as they were first conceived allowed workers to save a portion of their compensation on a tax-deferred basis. But the proven long-term appeal of Roth IRAs eventually led to this concept being applied to 401(k) and other deferral-type plans, including 403(b) and governmental 457(b) plans. The appeal of tax-free investment growth—instead of delayed taxation of compensation and investment growth—would prove as strong for employer plan participants as for Roth IRA savers.
EGTRRA made it possible for savers in 401(k) and 403(b) plans to designate amounts withheld from their pay as Roth rather than pretax deferrals beginning in 2006, rather than in 2002 when most of its provisions took effect. Since then, Roth deferrals have been added to governmental 457(b) plans as well.
Plan feature availability and participant preference drive the election of Roth vs pretax salary deferral choices. The Plan Sponsor Council of America (PSCA) in 2023 estimated that about 93 percent of 401(k) plans offer a Roth feature, and that about 21 percent of eligible participants make Roth deferrals, as opposed to about 74 percent of eligible participants who elect to make pretax deferrals.
Pension Protection Act of 2006
One of the most significant accomplishments of the Pension Protection Act of 2006 (PPA) was to make permanent many provisions of EGTRRA. These were set to expire in 2010 at the end of the 10-year window under which their tax impact had been calculated, which is common for budget reconciliation legislation.
This early permanence action in 2006 preserved the EGTRRA provisions that had enhanced salary deferral options, as well as other miscellaneous provisions. PPA provided relatively few new provisions with significant impacts on salary deferrals. But while few in number, some are expected to have a large impact.
Automatic Enrollment
For as long as there have been 401(k) plans, motivating employees to save within them has been a challenge. Some employees’ life circumstances may limit their ability to dedicate a portion of their compensation to saving. For others, it may simply be a matter of inertia, or indecision. The long-term consequence can be a lack of preparedness for retirement. In the short term, there can be unfavorable nondiscrimination testing consequences for 401(k) plans that lack a safe harbor design.
One solution is to make participation automatic for eligible employees, to require them to opt-out rather than to affirmatively opt-in to a plan. This can often help with nondiscrimination testing, since newly eligible employees are commonly non-HCEs, and the more individuals there are in that category who make contributions, the more likely it is that testing results will be favorable.
In addition—beyond nondiscrimination testing benefits—automatic enrollment is also seen as simply good public policy, encouraging more employees to save more for retirement.
PPA provided the following guidance for such arrangements, called automatic contribution arrangements (ACAs).
Eligible employees are treated as having elected to make salary deferrals at a rate specified by the plan, but have the option to opt out, or to elect a different deferral rate.
In the absence of an employee investment election, automatically-withheld deferrals are to be placed in an investment that meets Department of Labor default investment requirements.
A notice of participants’ rights must be provided before the start of each plan year.
A plan may permit employees who opt out to withdraw amounts that were automatically withheld from their pay without an affirmative election. An employee must make this request within 90 days after the first amount was automatically withheld.
In addition to these general automatic enrollment guidelines, PPA also established an alternative 401(k) safe harbor design known as the qualified automatic contribution arrangement, or QACA. Under a QACA plan design, eligible employees may be automatically enrolled and their salary deferrals automatically increased annually—in the absence of an affirmative election—up to a maximum of 10 percent. Like the basic 401(k) safe harbor plan design, this too satisfies nondiscrimination requirements if its conditions are met.
SECURE Act of 2019
The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 was the first of two similarly titled bills that together have provided substantial additions to the salary deferral landscape.
Accelerated Eligibility to Make Salary Deferrals
The SECURE Act of 2019 made it easier for employees who work less than full time to save for retirement, allowing those that work 500 or more hours in three consecutive years to become eligible to make salary deferrals into their employer’s 401(k) plan. Effective for 2025 and later plan years, SECURE 2.0 (discussed next) shortens the eligibility service requirement from three years to two years and applies this expanded eligibility coverage to ERISA-covered 403(b) plans.
Before this legislation, employers could require a year of service with 1,000 hours in order to enter a plan. Such employees need not be made eligible for employer contributions, like match or profit sharing, nor need they be included in a plan’s nondiscrimination testing.
SECURE 2.0 Act of 2022
Three years later, in 2022, encore legislation known as SECURE 2.0 further modified the rules for salary deferrals.
The “Super Catch-Up”
EGTRRA legislation in 2001 made it possible for those age 50 or older to make additional salary deferral contributions to their retirement plans. SECURE 2.0 created a special age class—age 60-63—that is eligible for even larger catch-up contributions. This amount was set for 2024 as the greater of $10,000 or 150 percent of the age-50 catch-up amount, to be indexed annually as cost-of-living adjustments dictate.
For 2026 this catch-up amount is $11,250 (unchanged from 2025) for 401(k), 403(b), and governmental 457(b) plans, and $5,250 for SIMPLE plans (unchanged from 2025).
The SIMPLE 10 Percent Increase
For SIMPLE IRA and SIMPLE 401(k) plans, SECURE 2.0 increased both pre-age-50 deferral limits and age-50 catch-up limits for 2024 by 10 percent above cost-of-living indexed amounts, with further indexing in subsequent years. This increase is automatic for a business with no more than 25 employees who earned at least $5,000 in the preceding year. For employers with 26 to 100 such employees, the enhanced deferral amounts must be elected, and—if so—the employer’s required contributions (three percent match, or two percent nonelective) are increased by one percent, respectively.
Mandatory Roth Catch-Up Contributions
Many 401(k), 403(b), and governmental 457(b) plans offer an opportunity to make salary deferral contributions as either pretax or Roth amounts. Roth deferrals are not excluded from current year taxation, but instead offer the potential for their earnings to be tax-free. This option exists for both base and catch-up salary deferrals of those age 50 and over.
Before SECURE 2.0, the choice between pretax and Roth deferrals was entirely the employee’s. Plans that offer a Roth option generally do not set limits on how much of an employee’s total deferrals can be Roth vs pretax. Following a two-year transition period, SECURE 2.0 has now “made the choice” for certain higher income individuals age 50 or over who make catch-up deferrals.
Employees whose 2025 FICA wages (reported in Box 3 of Form W-2) exceeded $150,000 (indexed from the SECURE 2.0 $145,000 statutory base) must make 2026 catch-up contributions as Roth amounts. This Roth catch-up deferral requirement does not apply to those with sole proprietor income (Form 1040, Schedule C) or partner income (Form 1065, Schedule K-1), or to the so-called “special catch-up” contributions made by long-term participants in 403(b) or governmental 457(b) plans.
Roth SIMPLE Contributions
SECURE 2.0 extended to SIMPLE IRA plans the ability to designate salary deferrals as Roth amounts. The IRS issued limited reporting guidance in 2024, but so far there has been limited availability through investment and IRA custodian firms that offer or administer SIMPLE IRA plans. (Because they are true 401(k) plans, SIMPLE 401(k) plans have had the ability to offer Roth deferrals since 2006, under the provisions of EGTRRA.)
Starter 401(k) Plans
SECURE 2.0 also created a new “starter,” deferral-only 401(k)/403(b) plan design, interest in which remains to be seen. Features include an annual contribution limit significantly lower than other 401(k) or 403(b) plans—$6,000, or $7,100 for those age 50 or older, indexed—automatic enrollment of those who meet eligibility conditions, no employer contributions permitted, and no nondiscrimination testing. Its appeal may prove to be the ability to make an IRA-sized plan contribution in addition to one’s IRA contribution, with no employer contribution commitment.
Retroactive Deferrals for Sole Proprietors
Prior law permitted the establishing of 401(k) plans as late as a business’s tax return deadline—including filing extensions—but permitted making salary deferrals only on income earned after the establishment date. SECURE 2.0 has provided a first-year-only opportunity for sole proprietors and single-member LLCs to establish a new 401(k) plan and fund it—including salary deferrals—as late as the business’s tax filing deadline, excluding filing extensions.
Conclusion
It's unlikely that members of Congress could have envisioned the ultimate effects of a seemingly unremarkable provision known as 401(k) tucked into the Revenue Act of 1978. It truly has led to a revolution in retirement saving.
