An elective-deferral contribution is an employee-authorized contribution made from an employee’s salary account to an employer-sponsored retirement plan. The employee needs to provide consent to the employer to deduct contributions. The funds contributed to retirement plans, including 401(k) and 403(b). Elective deferral contributions are a popular way to save for retirement as they have tax advantages and are auto administered by the employer.
How Elective-Deferral Contributions Work?
Elective deferral contributions allow deferring the tax payments on income and investment capital gains. They are the pre-tax income contributions made to employer-sponsored retirement plans, such as 401(k) and 403(b). It allows an employer to deduct money from an employee’s paycheck and deposit it into the employee’s retirement account. The deduction reduces the employee’s pay, but it also reduces their annual taxable income.
The above figure illustrates how elective deferral contributions work. Say a person with an annual salary of $100,000 contributes $10,000 as an elective deferral to the employer-sponsored retirement plan. It reduces the employee’s annual taxable income to $90,000. Hence, the employee would need to pay tax on $90,000 instead of $100,000. Taxes are deferred on the contributed amount of $10,000 and any derived investment gains until withdrawn from the account.
People usually withdraw at the time of their retirement or in an emergency. A tax penalty is applicable for early withdrawals. For example, an extra 10% tax as a penalty is applicable if an individual makes a withdrawal before age 59 ½. Furthermore, provincial and local taxes may apply for early withdrawals.
Pre-Tax vs. Post-Tax Contributions
Retirement plans are of two types: pre-tax, post-tax accounts, or both. Pre-tax contributions may help reduce taxes during pre-retirement years, while post-tax contributions may reduce one’s taxes during retirement.
A pre-tax contribution is when an employee or employer places money into a retirement account (401(k) or traditional IRAs) before the assessment of taxes. A pre-tax account is also known as a “tax-deferred” account. It defers paying taxes on the contribution amount and the earnings generated until an individual withdraws from the account in the future.
The idea is that one will be in a lower income tax bracket in retirement, which allows more favorable tax rates than one would be during their peak earning years. By deferring taxes, one can reduce their tax bill on the funds in the account.
Post-tax contributions are contributions made to investment or retirement accounts (Roth IRA) after deducting taxes from the taxable income. The contributions create a source of tax-free income in the future. Contributions are not tax-deductible during the saving years, but tax-free withdrawals can help reduce total taxable income when an individual retires.
When withdrawing from a post-tax (non-retirement account) investment, taxes are applicable on any investment gain above the original investment amount. Within post-tax accounts, taxes are not the same for all gains. The longer an individual holds an investment, the more favorable the tax situation.
Long-term investments deliver returns as qualified dividends and capital gains. Such a type of investment income is subject to a lower tax rate, and in some cases, long-term capital gains are not taxed at all.
Elective-Deferral Contribution Limits
A country’s revenue service agency establishes contribution limits. For the United States, the Internal Revenue Service established contribution limits for 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 to their retirement account or 100% of their compensation, whichever is less. Individuals above the age of 50 can make catch-up contributions of $6,500 more for a total of $26,000.
If the employee’s total contributions exceed the deferral limit, the difference is part of their gross income.
Employer Contribution Limit
The employer can make matching contributions for an employee who contributes elective deferrals (for instance, 30 cents for each dollar deferred). Employer matching contributions can be discretionary (contributed in some years and not in others) or mandatory, depending on the employer’s decision.
The total contributions from both the employee and employer to an employee’s retirement plan cannot exceed the following, whichever is less:
100% of the employee’s compensation; or
For 2020: $57,000 in total or $63,500 for individuals aged 50 and above, including $6,500 catch-up contribution
For 2021: $58,000 in total or $64,500, for individuals aged 50 and above, including $6,500 catch-up contribution
Take your learning and productivity to the next level with our Premium Templates.
Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI's full course catalog and accredited Certification Programs.
Already have a Self-Study or Full-Immersion membership? Log in
Access Exclusive Templates
Gain unlimited access to more than 250 productivity Templates, CFI's full course catalog and accredited Certification Programs, hundreds of resources, expert reviews and support, the chance to work with real-world finance and research tools, and more.