What Is a Deferral in a 401(k) and How It Works?

A 401(k) plan is a tax-advantaged retirement savings vehicle offered by many employers. It provides employees a structured way to set aside a portion of their earnings for future financial security. Understanding how contributions are made, particularly through deferrals, is central to utilizing this retirement savings tool.

Understanding 401(k) Deferrals

A 401(k) deferral is the portion of an employee’s gross salary contributed directly into their 401(k) retirement account through automatic payroll deductions, meaning the money is moved from the paycheck before the employee receives it. Employees specify either a percentage of their pay or a fixed dollar amount to be deferred. Once deferred, these funds are invested within the 401(k) plan according to the employee’s chosen investment options. The money then has the opportunity to grow over time through compounding returns, which can significantly increase the total value of the retirement savings. This mechanism allows for consistent, disciplined saving.

Types of 401(k) Deferrals

There are two primary types of employee deferrals in 401(k) plans: Traditional (Pre-tax) and Roth. The choice between these options depends on an individual’s current and anticipated future tax situation. Both types of deferrals contribute to the same overall annual limit set by the Internal Revenue Service (IRS).

Traditional 401(k) Deferrals

Traditional 401(k) deferrals are made with pre-tax dollars. This means the amount deferred is subtracted from the employee’s gross income before taxes are calculated, reducing current taxable income. Taxes on these contributions and their investment earnings are deferred until retirement, when withdrawals are taxed as ordinary income.

Roth 401(k) Deferrals

Roth 401(k) deferrals are made with after-tax dollars. Qualified withdrawals in retirement, including both contributions and earnings, are entirely tax-free. This can be beneficial for individuals who expect to be in a higher tax bracket during retirement.

Contribution Limits and Considerations

Employee Deferral Limits

The Internal Revenue Service (IRS) establishes annual limits on the amount employees can defer into their 401(k) plans. For 2024, the maximum employee elective deferral limit is $23,000. These limits are subject to periodic adjustments based on inflation and legislative changes.

Catch-Up Contributions

Individuals aged 50 and over are eligible to make additional “catch-up contributions” to their 401(k) plans. For 2024, the catch-up contribution limit is an additional $7,500, bringing the total possible employee deferral for those 50 and older to $30,500. These employee deferral limits are stipulated under Internal Revenue Code Section 402.

Overall Contribution Limits

Employer contributions, such as matching contributions or profit-sharing, also go into the 401(k) account, but they are separate from employee deferrals. There is a higher overall plan limit that includes both employee and employer contributions, governed by Internal Revenue Code Section 415. For 2024, the total contributions from all sources to an individual’s 401(k) account cannot exceed the lesser of 100% of the employee’s compensation or $69,000.

Managing Your Deferral

Employees can initiate, review, or adjust their 401(k) deferral amount or percentage at various points throughout the year. The process for managing these deferrals occurs through the employer’s Human Resources department, the company’s payroll system, or directly via the 401(k) plan administrator’s online portal. To make a change, an employee logs into the appropriate system, navigates to their 401(k) or retirement savings section, and locates the deferral election option. After confirming the change, it takes effect with the next available payroll cycle.