An employee deferral is the most common type of contribution to a defined contribution plan. Employee deferrals are also known as elective deferrals or salary reductions. Your employer may have different names for the same thing. They are quite simply dollars that are removed from your paycheck on a pretax basis and deposited into your account.
You may be asking what the benefit of a pretax employee deferral is compared to a post tax one.
Well, when your employer adopted the 401k arrangement of a Profit Sharing plan, the IRS basically gave your employer the right to defer your income taxes based on the amount you put into the plan, thus lowering your immediate taxable income. It really is a sweet deal.
Let’s say you make $30,000 a year and are paid bi-weekly. Each of your checks are $1,153.85 ($30,000/26) BEFORE taxes are withheld.
If you make no 401k contribution to a plan, then you owe taxes on your entire check of $1,153.85. This means that at a tax rate of 15% you would owe $173.08 in federal taxes and your net check would be $980.77.
Now, let’s say that you make a smart move and contribute 10% of your salary to the 401k. Before taxes are ever deducted from your check, $115.39 ($1,153.85*.10) will come out and be deposited into your account. So, instead of owing taxes on $1,153.08, you now only owe taxes on $1,038.46. It’s starting to get good!
At a 15% tax withholding rate, a total of $155.77 will now be deducted for taxes, whereas without making a 401k contribution you would have had $173.08 deducted in taxes. Are you starting to see the difference?
You can also look at it another way: while you had a total $115.39 taken from your check and sent to your 401k, the difference in your net check is only $98.08. Again, this is simply because you just effectively lowered your taxable income.
You might be looking at the above example and thinking that the difference isn’t really that large. True, but this is for one paycheck. Multiply the savings of this example by 26. Maybe then you will get the full grasp of how substantial the savings are.
Not to mention that by making the 401k contribution, you brought yourself one step closer to a more comfortable retirement and maybe scored a 401k employer match contribution along the way!