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 IRS will set different limits on how much an employee may defer into qualified retirement plans depending on different circumstances.
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 his 401(k). These deferrals amount to a total of $1,200 per year. As a result, this individual's pay is taxed at $38,800 that year instead of $40,000. But, because these contributions were tax-deferred, the employee would owe taxes on any amount withdrawn from the retirement plans. Withdrawals are called distributions. Distributions are taxed at the income rate the individual falls into when the funds are withdrawn.
Several restrictions apply when and under what circumstances an employee can make withdrawals from employer-sponsored retirement plans. 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. Employees may withdraw deferrals tax-free if they make them after they turn 59½.
Elective-Deferral Withdrawal Limits
Every year, the IRS sets rules on how much income employees can defer toward a qualified retirement plan. For 2020, individuals under the age of 50 can contribute up to $19,500 ($19,000 for 2019) into a 401(k). Those aged 50 and above can make catch-up contributions of an additional $6,500 ($6,000 for 2019) for a total of $26,000 ($25,000 for 2019). 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 ($19,000 for 2019). However, these rules apply only to elective-deferral contributions. They do not apply to matching contributions from an employer, non-elective employee contributions, or any allocations of forfeitures.
The total contribution limit from all of these sources (employee and employer) for 2020 is $57,000 ($56,000 for 2019). An elective-deferral contribution is also known as a "salary-deferral" or "salary-reduction" contribution.