What is an Elective Deferral?
An elective deferral is a contribution made to a retirement account directly from an employee’s salary.
Elective deferrals are a popular way to save for retirement because they are tax-advantaged and, once set up, are automatically administered by the employer.
Tax Benefits of Elective Deferral Contributions
Elective deferral contributions enable a saver to defer the payment of taxes on income and/or investment capital gains, depending on the type of account funded.
Employer-sponsored plans such as 401(k)s and 403(b)s can be funded with pre-tax income through an elective deferral. This is when an employer takes money directly from an employee’s paycheck and deposits it in a retirement account, skipping the payment of income taxes.
This reduces the employee’s paycheck, but it also reduces their taxable income for the year.
For example, if a person has an annual salary of $100,000 and they use an elective deferral to contribute $10,000 to a 401(k) account, their taxable income for that year is reduced to $90,000.
The graphic below illustrates this example.
Some employers allow workers to make contributions to Roth 401(k) plans, but these plans are funded with post-tax income.
This means the contribution is made after income taxes have been applied per the IRS rules on ROTH accounts. There are other benefits to ROTH plans, such as not having to pay taxes on withdrawals.
Roth 401(k) plans are distinct from Roth IRAs.
Elective deferrals are subject to an annual contribution limit set by the IRS.
Contribution limits vary depending on the type of account. For example, in 2019, the contribution limit for an individual 401(k) account was $19,000. The IRS adjusts contribution limits on an annual basis.
Although elective deferrals allow you to defer paying taxes, in most cases you will eventually have to pay taxes on income and capital gains. For pre-tax contributions, you typically pay taxes when you withdraw funds.
A major limitation with elective deferrals is that money is typically locked up for a specified amount of time or for a specific purpose.
For retirement accounts, if you withdraw funds before the age of 59½, you owe an additional tax penalty of 10 percent (for most account types) in addition to any other taxes owed on income and capital gains.
You can also make an elective deferral contribution to a Health Savings Account (HSA), but you can only use the funds in an HSA for qualified medical expenses. If you use HSA funds for a different purpose, you incur a tax penalty.