Elective Deferrals

Tax-advantaged retirement accounts help employees save for retirement. Employees can make pre-tax or post-tax contributions directly from their paychecks. This makes saving for retirement easier and often gives employees an extra tax benefit in their contributing years.

Retirement Plans: Salary Deferral Plans

401(k), 403(b), and 457 are three employer-sponsored salary deferred retirement plans. They give employees financial incentives to invest early for retirement. Salary deferral plans: 

• Give participants tax breaks to encourage more saving.

• Allow participants to select how much they want to invest each year up to a set maximum.

• Let employees transfer funds directly from a paycheck to their retirement plan. 

Elective vs. Mandatory

Elective deferrals are contributions that employees choose to have transferred from their paycheck to their retirement accounts. In 2023, individuals under 50 can elect to defer up to $22,500, and older individuals can elect to defer $30,000. Most employers offer elective deferrals, and new employees can decide how much they want to contribute to their accounts. Some public organizations and government entities, on the other hand, have mandatory deferral systems.

Plan Types

The five salary deferral retirement account types are:

• 401(k), the most popular type for public and private companies.

• 403(b), which hospitals, religious organizations, schools, and other nonprofits offer.

• 457(b), which is reserved for government employees.

• SIMPLE plans for small business employees.

Basics of Salary Deferrals

There are three main types of contributions for 401(k) accounts. Employees can make two of them: 

1. Salary deferrals, or regular pre-tax or post-tax contributions that are transferred to the retirement account through payroll deductions.

2. Catch-up contributions, which are additional contributions employees aged 50 and older can make to increase their overall contributions. 

The third type is employer contributions, in which employers directly contribute to employees’ retirement accounts. These are additional contributions outside of the established maximum contributions employees can make, and they generally match a set dollar amount or percentage of the employee’s total contributions. These contributions can be considered untaxed income for employees that make contributions, and it’s smart practice for employers to “max out” the potential employer contribution. For example, if an employer matches 25% of your contributions up to $3,000, an employee can receive all of that contribution by contributing $12,000 themselves. Combined, employee and employer contributions cannot exceed $66,000 in 2020.

Pre-tax salary deferrals are not taxed in the year they are contributed. This effectively lowers your tax bracket by lowering your taxable income level. While the money will be taxed when it is withdrawn during retirement, this delay lets the money grow untaxed for several years or decades.

Elective Deferral Contribution

Also called salary-deferral or salary-reduction contributions, these contributions are made directly from an employee’s paycheck. First, the employee authorizes a set contribution amount to their 401(k) or 403(b) account, then the business’s payroll department transfers that amount automatically. The IRS determines the maximum amount employees can defer in different circumstances, and the employer will decide if they allow pre-tax or after-tax deferrals.

How an Elective-Deferral Contribution Works

Employees make regular tax-deferred contributions that are automatically removed from their paycheck. The employer is responsible for transferring those funds to the correct retirement account, where the money is invested according to the employee’s established preferences. Once the employee makes a withdrawal, or a distribution, the withdrawn funds are taxed at the individual’s then-current income tax rate. Under most circumstances, employees can’t withdraw funds from a pre-tax retirement account until they are 59 1/2 years old and can face a 10% penalty for doing so. 

Some employers offer Roth 401(k) plans, which allow post-tax contributions. For this account type, employees pay income taxes the year they make the contribution and can withdraw the funds tax-free later.

Benefits of Salary Deferrals

The key benefits of making salary deferrals include:

• Tax savings in the current year.

• Being able to receive some or all of an employer’s contribution amount.

• Automated saving and investing for retirement.

How Employee Deferrals Reduce Your Taxes

When you contribute pre-tax dollars to a tax-advantaged retirement account, that money is effectively not considered income for that year. If you make $50,000 and contribute $5,000 to your retirement account, your taxable income lowers to $45,000, which reduces your total tax bill. Contributing that same $5,000 to a post-tax Roth IRA or Roth 401(k) will leave your taxable income at $50,000.

When to Make Deferrals

Investing in your pre-tax retirement account is a good strategy if you are currently able to meet your living expenses, have an emergency fund set aside, and don’t need immediate access to your money. It’s also a smart strategy for individuals who want to grow their retirement savings tax-free. However, individuals who can’t or struggle to meet their living expenses and need immediate access to all of their funds might consider saving their money in a savings account.

How to Make Salary Deferrals

Employees must generally be at least 21 years old or work for an employer for at least one year to be eligible for salary deferrals. Self-employed individuals can also make salary deferrals through a self-employed 401(k) account.

Making Investment Decisions

Many 401(k) plans allow employees to invest their contributions into specific funds online. Different 401(k) programs offer various funds. As a general rule of thumb, younger employees may prefer to invest in aggressive growth funds, while older employees are likely to focus on more conservative income funds.

Maximizing Your Salary Deferrals

Different tax-advantaged retirement accounts have different allowed maximum contributions:

• 401(k) and 403(b): Up to $22,500, or up to $30,000 for employees 50 or older.

• SIMPLE: Up to $15,500, or up to $19,000 for employees 50 or older.

Employers can also make contributions based on the specific retirement account program and each employee’s contribution amount. Some individuals can qualify for a retirement savings contributions credit, which reduces qualifying individuals’ federal income taxes.

Options When Leaving Your Employer

When employees leave their employer, they can transfer their tax-advantaged account to an account under their new employer or an IRA. While less common, you may also be able to cash out your account or leave the funds in your former employers’ plans. If you leave your employer before you’re fully vested in the retirement program, you might forfeit part of the employer contributions (but not your contributions).

Knowing how to maximize your salary deferrals is an important part of preparing for retirement. If you’re an employer plan administrator, contact us for educational resources and tax-advantaged plan management.