An elective-deferral contribution acts as a direct transfer from an employee's paycheck to their employer-sponsored retirement program, such as a 401(k), authorized by the individual. This form of contribution, also referred to as salary-deferral contribution, comes with IRS-set boundaries that determine the maximum amount an employee can contribute to a retirement plan.
An elective-deferral contribution paves the way for pre-tax contribution, thereby reducing an employee's taxable income. For instance, an individual with an annual salary of $40,000 who contributes $100 per month to their 401(k) pays tax for only $38,800 that year instead of the full $40,000. Despite a tax exception at the start, distributions are subject to tax at the income tax rate during retirement.
There are restrictions regarding withdrawals from the retirement plan, like a 10% penalty tax on withdrawals made before age 59½, barring a qualifying hardship withdrawal. Additional state and local taxes may be imposed on early withdrawals.
Some employers accommodate contributions to Roth 401(k) plans. Here, contributions are made post-tax, indicating the funds have been taxed prior. This exempts employees older than 59½ from paying tax on contributions, but not on earnings upon withdrawal.
IRS rules cap the yearly 401(k) contribution at $24,500 for those under 50, while people aged 50 and above can additionally contribute up to $8,000, totaling $32,500. In the case of individuals aged 60 to 63, an increased catch-up contribution of $11,250 is allowed. If an employee has both a traditional and Roth 401(k) plan, their total contribution across both plans cannot exceed $24,500.
The stated guidelines are exclusively for elective deferral contributions and not for employer-matched contributions, non-elective employee contributions, or allocation of forfeitures. The IRS also limits the total contribution from all sources to an employee's retirement plan-the lesser of 100% of the employee's wage, or capped amounts depending on their age.
To reap the most benefits from a 401(k), employees should ideally maximize their allowable pre-tax contributions which reduces their taxable income and potential tax liability. However, one must be mindful of crossing contribution limits to avoid penalties.