Elective-Deferral Contribution

What Is an Elective-Deferral Contribution?

An elective-deferral contribution is made directly from an employee's salary to his or her employer-sponsored retirement plan such as a 401(k) or 403(b) plan. The employee must authorize the transaction before the contribution can be deducted.

Elective-deferrals can be made on a pre-tax or after-tax basis if an employer allows. The Internal Revenue Service (IRS) establishes limits on how much an employee can defer or contribute to a qualified retirement plan. An elective-deferral contribution is also known as a "salary-deferral" or "salary-reduction" contribution.

How an Elective-Deferral Contribution Works

Elective-deferral contributions made into traditional 401(k) plans are made on a pre-tax or tax-deferred basis, effectively reducing an employee's taxable income. For example, suppose an individual making $40,000 a year decides to contribute $100 per month into their 401(k). These deferrals total $1,200 per year. As a result, the employee's pay is taxed at $38,800 that year instead of $40,000. 

Since there's a tax-deduction upfront, any withdrawals or distributions in retirement are taxed at the income tax rate for the retiree at that time. However, several restrictions apply as to when and under what circumstances an employee can make withdrawals from an employer-sponsored retirement plan. For example, an additional 10% penalty tax may apply if an individual makes a withdrawal before age 59½ — assuming the employee meets the conditions that allow him or her to take an early distribution. Furthermore, state and local taxes may be assessed for early withdrawals.

Some employers will allow workers to contribute toward Roth 401(k) plans. Contributions made to these plans are made on an after-tax basis. After tax-basis means the funds are taxed before they were deposited into the retirement plan. Since there's no pre-tax benefit with Roth 401(k)s, employees can withdraw deferrals tax-free as long as they're over the age of 59½.

Elective-Deferral Contribution Limits

The IRS has established limits on how much money can be contributed to an employee's qualified retirement plan.

Employee Contribution Limit

For 2020 and 2021, individuals under the age of 50 can contribute up to $19,500 into a 401(k). Those aged 50 and above can make catch-up contributions of an additional $6,500 for a total of $26,000. These rules apply to Roth 401(k)s as well.

IRS rules also apply if you have multiple 401(k) accounts. Say a person under age 50 invests in a traditional 401(k) and a Roth 401(k) plan. That person can make elective-deferral contributions of up to $19,500 for 2020 and 2021. 

Employee and Employer Total Contribution Limit

The rules stated earlier apply only to elective-deferral contributions. They do not apply to the matching contributions from an employer, non-elective employee contributions, or any allocations of forfeitures. The IRS limits the total amount that can be contributed to an employee's retirement plan from all sources, including the employer's matching and the employee's contributions.

The total contributions to an employee's retirement plan from both the employee and employer cannot exceed the lesser of: