What Is an Elective Deferral and How Does It Work?

Saving for retirement often involves using tax-advantaged accounts, and elective deferrals play a key role in many employer-sponsored plans. These contributions allow employees to set aside a portion of their paycheck before or after taxes, depending on the plan type. Understanding how they work helps individuals maximize savings while benefiting from tax advantages.

Plan Eligibility Requirements

Not all employees can immediately participate in an employer-sponsored retirement plan. Many plans impose criteria based on length of service, hours worked, or employment classification. A 401(k) plan, for example, may require 12 months of service before contributing and at least 1,000 hours worked in a year.

Employers have flexibility in setting these rules but must comply with federal regulations, including the Employee Retirement Income Security Act (ERISA), which ensures fair eligibility policies. The SECURE 2.0 Act expands access by requiring that, starting in 2025, long-term part-time employees working at least 500 hours per year for three consecutive years be allowed to participate in a 401(k).

Certain employees may be excluded based on plan design. Union employees covered by collective bargaining agreements, non-resident aliens without U.S. income, and some highly compensated employees may face different eligibility rules. Employers must also comply with nondiscrimination testing to prevent plans from disproportionately benefiting higher earners.

Annual Contribution Caps

The IRS sets annual limits on elective deferrals, adjusting them for inflation. In 2024, the contribution limit for 401(k), 403(b), and most 457(b) plans is $23,000. Employees aged 50 or older can contribute an additional $7,500, bringing their total to $30,500. These limits apply per individual, so those with multiple employers must ensure their combined contributions do not exceed the cap.

Total contributions—including elective deferrals, employer matching, profit-sharing, and after-tax contributions—are subject to a separate limit. In 2024, the overall contribution cap for defined contribution plans is $69,000, or $76,500 for those eligible for catch-up contributions.

Some plans have different rules. SIMPLE IRA plans, often used by small businesses, have a lower elective deferral limit of $16,000 in 2024, with a $3,500 catch-up contribution for those 50 and older. Government and nonprofit employees using 457(b) plans may qualify for special catch-up contributions in the three years before retirement, potentially doubling the standard limit.

Tax Effects and Considerations

Elective deferrals provide tax benefits that impact both current income and future retirement savings. Traditional pre-tax contributions reduce taxable income in the year they are made, lowering adjusted gross income (AGI). A lower AGI can increase eligibility for tax credits like the Saver’s Credit, which provides up to a 50% credit on retirement contributions for low- to moderate-income earners.

However, withdrawals from pre-tax accounts in retirement are taxed as ordinary income. Required minimum distributions (RMDs), which begin at age 73 under the SECURE 2.0 Act, can push retirees into higher tax brackets. Converting portions of pre-tax savings into Roth accounts during lower-income years can help manage future tax liability.

Roth elective deferrals do not reduce taxable income when made, but qualified withdrawals—including earnings—are tax-free. To qualify, the account holder must be at least 59½ and have held the Roth account for five years. Roth accounts also avoid RMDs, allowing retirees to preserve tax-free growth.

Payroll Deductions

Elective deferrals are deducted automatically from an employee’s paycheck, ensuring consistent contributions. Employees typically choose a fixed dollar amount or percentage of their salary to defer, with adjustments allowed during open enrollment or after a qualifying life event.

The timing of payroll deductions can affect contribution strategies. Some plans process deferrals each pay period, while others allow lump-sum contributions, such as from bonuses. Employees can maximize savings by increasing contributions during lower-expense months or allocating a portion of bonuses toward retirement.

Employers must deposit withheld funds into the plan promptly. Small businesses with fewer than 100 participants must remit contributions as soon as administratively possible, while larger employers must do so by the 15th business day of the following month.

Employer Matching Fundamentals

Many employers offer matching contributions to encourage retirement savings. These matches typically follow a formula, such as a dollar-for-dollar match up to a certain percentage of salary or a partial match, like 50 cents per dollar contributed up to a specific limit. For example, an employer might match 100% of the first 3% of salary deferred and 50% of the next 2%, meaning an employee contributing 5% would receive an additional 4% from their employer.

Matching contributions are often subject to vesting schedules, which determine when employees gain full ownership of employer-provided funds. Some plans use graded vesting, where ownership increases incrementally over several years, while others apply cliff vesting, granting full ownership after a set period, such as three years of service. Employees who leave before becoming fully vested may forfeit some or all of their employer’s contributions.

Distribution and Withdrawal Guidelines

Withdrawals from traditional accounts before age 59½ generally incur a 10% early withdrawal penalty in addition to regular income tax, though exceptions exist for disability, medical expenses exceeding 7.5% of AGI, or a first-time home purchase from an IRA.

Once individuals reach retirement age, RMDs dictate when and how much must be withdrawn annually. Under the SECURE 2.0 Act, RMDs begin at age 73, with penalties for failing to withdraw the required amount reduced from 50% to 25%, or 10% if corrected within a specified timeframe. Starting in 2024, Roth 401(k) accounts will no longer require RMDs, allowing retirees to preserve tax-free growth longer.