What it means
The word "elective" means the employee chooses whether to take part and how much to put in. The word "deferral" means the pay is delayed, because the money is set aside for retirement rather than spent now.
The payment is taken directly from each paycheque by the employer and sent to the plan. There are usually two main types.
With a traditional deferral, the contribution is made before income tax, which lowers taxable pay today, and tax is paid when the money is withdrawn in retirement. With a Roth deferral, the contribution is made from pay that has already been taxed, and qualifying withdrawals later can be tax free.
Tax authorities set an annual limit on how much an employee can defer, and the limit is reviewed regularly. Employees who are older than a set age may be allowed to add extra "catch-up" contributions.
Because the limits change, always check the current figure before planning your contributions. Employers often add a matching contribution, which is free money paid in only if the employee contributes.
A common design might match 50 cents for every dollar the employee defers, up to a stated percentage of pay. Matching contributions are separate from the employee's own deferrals and usually have their own limits and vesting rules (the time you must work before the money is fully yours).
For employers and finance teams, elective deferrals bring responsibilities. The deductions must be paid into the plan promptly, accurately recorded and tested to make sure the plan does not favour highly paid staff.
For employees, the practical point is simple: contributing at least enough to earn the full employer match is usually the first step in a sensible savings plan. Many plans now use automatic enrolment, which sets a default deferral rate unless the employee opts out.
Some also use automatic escalation, which raises the rate by one percentage point each year until it reaches a target. Both features have been shown to lift participation and savings rates, because people tend to stay with the default option.
In practice
Real-world examples.
Example
A software engineer sets her deferral at 8% of her $150,000 salary, which comes to $12,000 a year. Her taxable pay falls by the same amount, and her employer deposits a matching contribution as well. Over a 30-year career, the early habit of saving makes a large difference to her retirement pot.
Example
A restaurant owner offers a plan to his 20 staff for the first time. Eight choose a Roth deferral of 3% of pay because they expect to be in a higher tax bracket later in their careers. He explains to staff that the Roth option costs more take-home pay today but may save tax later.
Example
A 55-year-old teacher realises she is behind on retirement savings and adds a catch-up contribution on top of her normal deferral. She cuts back on holiday spending to afford the extra $500 a month. Her adviser confirms that this catch-up amount sits on top of the normal limit.
Formula
Calculation
Annual deferral = salary x deferral percentage. Tax saving on a traditional deferral = deferral x marginal tax rate.
Worked example: an employee earns $120,000 and elects to defer 10%. The employer matches 50% of deferrals up to 6% of salary.
1. Annual deferral = $120,000 x 10% = $12,000, which is $1,000 a month
2. Tax saving at an assumed 24% marginal rate = $12,000 x 24% = $2,880
3. Match is capped at 6% of salary = $120,000 x 6% = $7,200, and 50% of that = $3,600
The employee's total savings added in the year are $12,000 + $3,600 = $15,600, while take-home pay falls by only $12,000 - $2,880 = $9,120.Case study
Seen in the real world.
Cobalt Ridge Engineering is an illustrative, fictional company with 120 employees. Participation in its retirement plan had stalled at 55%, and the finance director suspected that many staff did not understand the employer match.
She ran a short lunchtime session using simple examples, and showed that an employee earning $60,000 who deferred 6% would receive an extra $1,800 from the company each year. The company also switched to automatic enrolment at 5%, with staff free to opt out.
Within a year, participation reached 90%, and the average deferral rose to about 7% of pay. The illustrative lesson is that clear explanations and sensible defaults can change savings behaviour without any pressure on employees. The change cost the company about $90,000 a year in extra matching contributions, which the board judged to be worthwhile for staff retention.
Watch out
Common mistakes.
- Contributing less than the amount needed to earn the full employer match, which leaves free money unclaimed.
- Forgetting that the annual deferral limit applies across all of your plans combined if you change jobs mid-year.
- Assuming deferred money can be freely withdrawn, when early withdrawals often trigger taxes and penalties.
Questions
People also ask.
Is an elective deferral the same as an employer contribution?
No, an elective deferral comes from your own pay, whereas an employer contribution is paid in addition by the company.
Can I change my deferral amount?
Most plans let you change the percentage at set times or at any time, so check your plan rules.
Are deferrals subject to payroll taxes?
In many systems, contributions are still subject to social security and similar payroll taxes even though income tax is deferred, so confirm how your country treats them.
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