What it means
When you join an employer's retirement plan, you are usually asked to pick a percentage of your pay to contribute. That choice is the elective deferral, and the employer sends the money to the plan rather than to your bank account.
Because it happens through payroll, it is automatic once set up. The main attraction is tax.
In many plans the deferral comes out of your pay before income tax is calculated, so your taxable income is lower this year, and tax is paid later when you withdraw the money in retirement. Some plans also allow an after-tax version, where tax is paid now and withdrawals later may be tax-free.
Governments set an annual limit on how much an individual can defer, and the limit is reviewed regularly. There may be extra allowances for older workers, and the details change, so you should check the current rules with your plan provider or tax authority.
The limit applies to your own deferrals across all plans, not to each plan separately. Employers often add their own money.
A common arrangement is a match, where the employer adds a set amount for each dollar you defer, up to a cap. Deferring at least enough to earn the full match is widely viewed as one of the simplest ways to boost retirement savings.
For a business, elective deferrals are not an expense of the company, because they are the employee's own money. The employer's match, however, is a cost and appears in the accounts as part of employee benefits.
Payroll teams must send the deferrals to the plan promptly and report them correctly. Deferrals are generally locked in until retirement age, apart from limited exceptions, and early withdrawals may attract tax and penalties.
This is the main trade-off: you give up access to the money now in exchange for tax benefits and long-term growth.
In practice
Real-world examples
Example 1
A newly hired marketing executive earning $65,000 is asked to choose a deferral rate. She elects 5%, which is $3,250 a year, and her employer matches it dollar for dollar. Her take-home pay falls only slightly because of the tax saving, while her retirement account grows by $6,500 in the first year.
Example 2
A senior engineer earning $150,000 wants to save as much as possible. He sets his deferral to reach the annual limit and then stops, because he cannot defer more than the limit. His payroll team adjusts his pay to avoid an excess contribution.
Example 3
A small business owner offers a retirement plan for the first time. She tells staff that the deferrals belong to them and are kept separate from company funds. The payroll provider transfers the money to the plan administrator within days of each pay date.
Think of it
Imagine ordering a takeaway meal, but instead of paying for the whole feast right now, you ask the restaurant to pack away a portion of your favourite dish and put it in the freezer for next year, meaning you only pay the tax on what you eat today.
Formula
Calculation
Elective deferral = Salary x Deferral percentage
Employer match = Salary x Lower of (employee deferral percentage, match cap) x Match rate
Suppose an employee earns $80,000 and elects to defer 6%.
Elective deferral = 80,000 x 6% = $4,800 a year, or $400 a month.
If the employee's marginal tax rate is 22%, the immediate tax saving is 4,800 x 22% = $1,056, so the take-home cost of the deferral is 4,800 - 1,056 = $3,744.
If the employer matches 50% of the first 6% of pay, the match is 80,000 x 6% x 50% = $2,400.
Total going into the plan this year = 4,800 + 2,400 = $7,200.Case study
Seen in the real world
Brookfield Logistics is an illustrative, fictional company with 120 employees, where only 40% took part in the retirement plan. The human resources director suspected that many staff did not understand how deferrals worked.
She ran a short workshop explaining that a 4% deferral on a $50,000 salary was $2,000 a year, with an immediate tax saving and a company match of 50% on the first 4%. She also moved to automatic enrolment at 4%, with the option to opt out.
Within a year, participation rose from 40% to 85%. The illustrative lesson is that clear explanation and sensible defaults can change behaviour more than the plan rules themselves.
Watch out
Common mistakes
- Failing to defer enough to receive the full employer match, which is effectively declining free money.
- Thinking that the deferral is a cost to the employer, when it is the employee's own pay.
- Forgetting that the annual limit applies across all plans an individual belongs to, which can lead to excess contributions.
Questions
People also ask
Is an elective deferral the same as a pension contribution?
It is one kind of pension contribution, specifically the amount an employee chooses to take from their own pay and send to the plan.
Can I change my deferral rate?
Most plans let you change it at set times, and many allow changes at any time, so check the rules of your own plan.
What happens if I withdraw the money early?
Early withdrawals are often taxed and may carry a penalty, apart from limited exceptions set out in the plan and tax rules.