Elective Deferrals: Definition, Benefits & How They Work

Planning for retirement begins much before retirement age, and an intelligent person will start saving and contributing to their retirement plan as soon as they start earning. Saving a portion of income/salary for the future ensures a safe and secure life post-retirement.

Elective deferrals give employees the option to contribute a part of their pre-tax salary to a qualified retirement plan. It is a voluntary decision of the employee but a crucial one for retirement, as elective deferrals are tax deductible and guarantee savings for retirement. Many employers also contribute to the employee’s elective deferrals in matching proportions, further increasing the employees’ retirement savings pool.

In this article, we will discuss elective deferrals in depth, how they work, and their benefits, and clarify the common questions often asked about them.

What Is Elective Deferral?

A contribution made directly from an employee’s salary to their employer-sponsored retirement plan is an elective deferral. The employee needs to consent to the contribution before the amount is deducted from his salary. Elective deferral plans include retirement plans such as 401(k), 403(b), SARSEP, and the SIMPLE IRA plan.

Types of Elective Deferral Plans

Many elective deferral plans are available, each with advantages and disadvantages. By understanding each plan, an employee can decide which elective deferral plan to invest in to maximize retirement savings.

• 401(k) Plans

  Many private sector employers offer 401(k), one of the most popular elective deferral plans. There are two variations:

  1. Traditional 401(k): Employees can contribute pre-tax money
  2. Roth 401(k): Employees contribute post-tax, but the withdrawals post-retirement become tax-free.

  Both of the above options have tax advantages and investment options; the employee should select the one that best suits his preferences and needs.

• 403(b) Plans

  403(b) plans are similar to 401(k) plans, but they are designed specifically for employees of non-profit organizations, public schools, and a few religious institutions.

  403(b) plans also allow pre-tax contributions or tax-deferred growth, depending on the employee’s needs. The investment options under 403(b) are not as vast as those under 401(k) plans, but they are still diverse enough.

• 457(b) Plans

  405(b) plans are similar to 401(k) and 403(b) plans, but they are for government employees and some non-profit organizations.

  405(b) plans have a unique withdrawal rule: The employee can withdraw from it before retirement without incurring penalties.

• SIMPLE IRA

  Savings Incentive Match Plan for Employees (SIMPLE) IRA is a special retirement plan, especially for businesses with 100 or fewer employees.

  SIMPLE IRAs also allow employees to make pre-tax contributions, and the employer must match the contribution. Though the investment options are wider in SIMPLE IRAs than in 401(k) and 403(b), the contribution limits are lower.

• Thrift Savings Plan(TSP)

  This retirement plan is specifically only for federal and uniformed services employees.

  The benefits under TSP are similar to those under a 401(k), but its administrative costs are lower, making it more attractive for eligible employees.

How Does Elective Deferral Work?

Employers cut a part of their employees’ salaries to contribute to elective deferral plans such as 401(k), 403(b), etc. This cut reduces the employee’s salary but also reduces their taxable income, reducing their tax liability. So, elective deferral allows deferred payment of taxes on income and capital gains. The tax is deducted at the time of withdrawal at the retiree’s prevailing income tax rate.

• Suppose an individual earning $50,000 a year contributes $200 per month to their 401(k).
• The total yearly deferral equals to $2,400($200 * 12 months)
• Thus, the employee’s salary is taxed at $47,600 ($50,000-$2,400).
• The tax on $2,400 is deferred until withdrawal.

Elective-Deferral Contribution Limits

The revenue service agency of any country decides the contribution limits. In the United States, the Internal Revenue Service decides the limit on the money contributed to the employee’s qualified retirement plan. The elective deferral limit for 2024 is:

• Employee Contribution Limit

  – Individuals under the age of 50 can contribute the following to 401(k):

  • up to $22,500 in 2023
  • up to $23,000 in 2024

  – Individuals above 50 can make catch-up contributions of an additional $7,500 for 2023 and 2024.These rules also apply to Roth 401(k)s.

• Employer Contribution Limit

  The employer can make matching contributions to the elective deferrals of his employee. It depends on the employer whether his contributions are discretionary or mandatory.

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

  • 100% of the employee’s compensation; or
  • For 2023: $66,000 or $73,500, including catch-up contributions for those aged 50 and over
  • For 2024: $69,000 or $76,500, including catch-up contributions for those aged 50 and over

Withdrawal Rules and Penalties

All employees wishing to contribute to elective deferrals should know the withdrawal rules and penalties.

• Age Requirements for Withdrawals: As a general rule, employees 59½ years old can withdraw funds from elective deferral without penalties. If an employee withdraws before reaching the necessary age, he will have to pay a penalty of 10% early withdrawal in addition to the income tax on withdrawal.
• Early Withdrawal Penalties: Usually, early withdrawal leads to a 10% penalty in addition to the income tax on withdrawal. Under exceptional circumstances, there are a few exceptions to this rule, where penalty-free withdrawals are possible.
• Required Minimum Distributions (RMDs): Once the employee turns 72, he must start withdrawing required minimum distributions (RMDs) from his elective deferral. RMDs are calculated based on the account balance and the employee’s life expectancy. If any employee does not take RMDs, a substantial tax penalty is levied.
• Special Circumstances for Penalty-Free Withdrawals: Certain exceptions, such as financial hardship, disability, qualifying education expenses, etc., allow employees to make penalty-free withdrawals from their elective deferral plans before reaching the age of 59½.

Advantages of Elective Deferrals

Individuals looking to save for retirement and making smart retirement plans benefit greatly from elective deferrals. Elective deferrals provide a lot of benefits, such as:

• Tax Benefits: Elective deferrals offer many tax benefits in the form of pre-tax contributions and tax-deferred growth. Pre-tax contributions reduce employees’ taxable income, resulting in reduced tax liability.
• Employer Matching Contributions: Many employers contribute a portion to their employees’ elective deferrals, which increases the employees’ retirement savings.
• Investment Flexibility: Elective deferral plans give the flexibility to invest in various options such as mutual funds, stocks, bonds, etc. This helps diversify the portfolio and manage risk.
• Long-Term Savings Potential: Since contributions to the elective deferral plan are regular, employees can take advantage of compound interest and accumulate a large amount of money for their retirement.

Final Thoughts

Elective deferral plans are a great way to secure your finances after retirement and ensure that you live a comfortable life once you have retired. As they offer tax advantages, matching employee contributions, and flexibility of investments, they play a crucial role in retirement planning.

It is essential to know the types of elective deferral plans available, their contributions and withdrawal rules and limitations, their tax advantages, etc.

If you want to contribute to elective deferral plans or need any guidance related to your retirement plans and investments, contact us today. We will help you take control of your retirement.

FAQs

Are Elective Deferrals Tax Deductible?

No, elective deferrals are not tax deductible. Your contribution to any elective deferral plan lowers your taxable income by that much. So that reduces your tax liability.

Are there limits on the amount of elective deferrals I can make?

Yes, the IRA limits the amount of elective deferrals an individual can make in a year.

Can I make changes to my elective deferrals during the year?

Yes, most elective deferral plans allow you to make changes during the year. However, these might be subject to certain restrictions or deadlines set by your employer or plan provider.

What happens if contributions are late?

Late contributions have quite a few implications. Firstly, it can lead to your plan getting disqualified. Secondly, if your contributions are late, you may have to pay a 15% excise tax if the delay is a prohibited transaction

What happens if I exceed the elective deferral limit?

If you have contributed more than the limit allowed, you should withdraw your money by April 15 of the following year to avoid double taxation. Excess contributions may also attract additional penalties and tax complications.

Can I still contribute to an IRA if I’m participating in an elective deferral plan?

Yes, it is possible to contribute to both an IRA and a 401(k) plan. However, the tax deductibility of your traditional IRA contributions might be affected if you participate in an employer-sponsored retirement plan and your level of income.

What should I do if I change jobs?

If you change your job, there are several options available. You can leave the funds in your former employer’s plans, switch them to your new employer’s plan whenever allowed, or roll them into an IRA.