In the past, most employees could expect a healthy pension from their employer with a guaranteed income upon retirement. Today, the responsibility for saving for retirement has shifted largely to employees. And yet research from AARP shows that nearly half of Americans do not have access to retirement plans at work.
This presents a big opportunity for people-centric employers. Businesses that provide dignified and accessible retirement savings plans have the edge when it comes to hiring, retention, and productivity. In fact, employer-provided retirement savings are second-most expected benefit by American workers across all income levels, as Sunny Day Fund discovered when compiling our 2022 financial well-being report:
And there’s an even more compelling stat for employers: retirement savings is the #1 financial benefit that would influence an employee’s decision to join a company. Based on the data, it’s probably safe to say that employer-provided retirement savings plans are table-stakes for attracting and retaining employees at entry-, mid-, and senior-levels.
Employers can use this information to remain competitive in today’s tight labor market. Enabling employees to contribute a portion of their income to a savings account for retirement, often with tax advantages, and sometimes with a matched contribution from the employer, is a competitive advantage and a smart business decision.
To help HR leaders and execs understand that what, why, and how of offering impactful retirement plans, this article will cover:
- Retirement Savings Plan Legal Requirements for Employers
- Types of Employee Retirement Plans
- Employer Matching Contributions for Retirement Savings
- Upcoming Changes to US Retirement Plans
- What Type of Retirement Plan Should You Choose
- How Early Withdrawals Impact Employers and Employees
Retirement Plans & Legal Requirements for Employers
In most states, there are no laws that require employers to offer retirement savings plans to their employees. However, that’s starting to change, with a wave of states creating state-wide retirement savings programs – from Oregon and Colorado to Maryland and Virginia.
When you do decide to offer a retirement plan you must ensure that you follow state and federal legal requirements. As a retirement plan sponsor, you also have a fiduciary responsibility to ensure the investment opportunities you offer to employees are sound—more on that in the next section.
Employee Retirement Income Security Act (ERISA) Requirements
Established in 1974, ERISA is a federal law that sets standards for voluntary retirement and health plans in private industry.
To remain compliant, you must meet the following requirements set forth under ERISA:
- Information disclosure: you must regularly provide employees with information about the plan, investment opportunities and funding
- Participation Standards: you must determine standard criteria for participation, vesting, benefit accrual and funding
- Fiduciary Responsibilities: anyone who exercises control over the plan’s investments must uphold principles of conduct and may be responsible for losses in the case of negligence
- Grievance and appeals process: participants have the right to sue for benefits or breaches of fiduciary responsibilities
- Guarantee of payment: in case a defined benefits plan is terminated, payment must be guaranteed through a Pension Benefit Guaranty Corporation
It’s important to understand that as retirement plan sponsors, employers have a fiduciary responsibility to their beneficiaries. The Department of Labor explains:
“The primary responsibility of fiduciaries is to run the plan solely in the interest of participants and beneficiaries and for the exclusive purpose of providing benefits and paying plan expenses. Fiduciaries must act prudently and must diversify the plan’s investments in order to minimize the risk of large losses. In addition, they must follow the terms of plan documents to the extent that the plan terms are consistent with ERISA. They also must avoid conflicts of interest. In other words, they may not engage in transactions on behalf of the plan that benefit parties related to the plan, such as other fiduciaries, services providers or the plan sponsor.”
This means that as an employer, you must not only provide employees with investment options, but you must also take responsibility for making sound investments and monitoring these investments over time. The consequences for neglecting fiduciary duty as an employer can be serious: in April 2022 Wells Fargo found itself on the hook for a $32.5 million settlement to employees alleging their 401(k) plan investments were mismanaged.
Types of Employee Retirement Plans
As a first step to providing retirement savings to your team, you’ll need to determine what type of plan to offer. There’s a fair amount of customization in the world of retirement plans; in fact, the word ‘plan’, when used by employers or financial planners in the retirement savings context, doesn’t refer to a standardised program, but rather the employer’s specific implementation of a retirement savings benefit. Each plan is essentially unique.
That said, there are similarities across different plans. The type of plan best suited for you depends partly on your goals and preferences as an employer, and partly on the options available based on the legal classification of your business.
Defined Contribution vs Defined Benefit Retirement Plans
There are two broad categories that retirement plans fall under, defined contribution plans and defined benefit plans. The key difference lies in who is primarily responsible for funding the accounts.
Under a defined benefit plan, also known as a traditional pension plan, the employer funds and guarantees a specific amount of income for the employee upon retirement. In this case, the employer takes on the risk that the returns on their investments may not cover the full amount of income guaranteed to the employee.
Under a defined contribution plan, the employee is primarily responsible for funding their account by deferring a portion of their gross salary, while the employer has the option of matching contributions if they choose. These plans are less risky and require less administrative work for the employer because the employee is ultimately responsible for managing their own funds.
Within these broad categories there are several types of retirement plans recognized by the IRS:
- Individual Retirement Arrangements (IRAs)
- Roth IRAs
- Traditional 401(k) Plans
- Roth 401(k) Plans
- SIMPLE 401(k) Plans
- 403(b) Plans
- SIMPLE IRA Plans (Savings Incentive Match Plans for Employees)
- SEP Plans (Simplified Employee Pension)
- SARSEP Plans (Salary Reduction Simplified Employee Pension)
- Payroll Deduction IRAs
- Profit-Sharing Plans
- Money Purchase Plans
- Employee Stock Ownership Plans (ESOPs)
- Governmental Plans
- 457 Plans
- Multiple Employer Plans
Defined contribution plans are much more common than defined benefit plans today, and among these, 401(k) plans are the most common among employers. The rest of this post focuses on defined contribution plans, given their ubiquity and popularity.
What’s the Difference Between a 401(k), a 403(b) and a 457 Plan?
401(k), 403(b) and 457 plans are all defined contribution plans offering tax-advantaged retirement savings for employees. One of the key differences between these plans is the employer’s status, or whether they’re private/for-profit, non-profit or government/non-government organization. Additionally, each of these plans has different investment options and administrative requirements.
401(k) plans are the most common employer-sponsored retirement plans today. These plans allow employers to defer a portion of an employee’s wages to a retirement account, as determined by the employee, and the employer has the option to contribute as well – typically through a ‘match’ on all or part of their employee’s contributions, up to $61,000 in 2022, and contingent on those contributions meeting ERISA testing requirements.
Private, for-profit companies are eligible for 401(k)s. As the 401(k) sponsor, employers are responsible for providing investment options and monitoring their suitability. Most employers offer at least three investment options such as target date funds, mutual funds, exchange-traded funds (ETFs), guaranteed investment contracts (GICs), company stock or annuities.
While employers must select the investment options, it is up to the employees to choose how to invest their own funds. In the cases of auto-enrolment, most employers may opt to default employees into a target-date fund or the money-market account equivalent in the plan.
Sometimes called tax-sheltered annuities (TSAs), 403(b) plans are a common option for non-profits. To be eligible for a 403(b) plan you must be a public school, college, university, church, or a 501(c)(3) charitable organization. Compared to 401(k)s, 403(b) plans are limited in their investment options. Only mutual funds and annuities are available.
To be eligible for a 457 plan, employers must be state or local government or a tax-exempt organization under IRC 501(c).
Traditional vs Roth 401(k)s
There are two 401(k) options to consider: traditional and Roth.
A traditional 401(k) is funded with pre-tax contributions, meaning the employee does not pay tax on that income in the current year but instead pays tax on the income upon withdrawal in retirement. Investment gains within the account are also tax-deferred until withdrawal.
A Roth 401(k) is funded with after-tax income, and withdrawals are tax-free upon retirement as long as the funds have been in the account for at least 5 years. Unlike a traditional 401(k), investment gains within a Roth 401(k) account are tax-free.
As an employer if you wish to offer a Roth 401(k) you must also offer a traditional 401(k) as an option. If you choose to offer both, you can give employees the option to contribute to one or the other, or both.
401(k) Contribution Limits
There are limits on the amount employees can contribute to a 401(k), which change from year to year and depend on the employee’s age.
For 2022, the maximum allowable tax-deferred contribution is $20,500. Employees over age 50 may make an additional “catch-up contribution” to their plan, up to $6,500 in 2022.
There is also a limit on employer-matched contributions. As of 2022, the total annual contribution to an employee’s retirement savings account including employee salary deferrals and employer matching cannot exceed the lesser of 100% of the participant’s compensation, or $61,000 ($67,500 including catch-up contributions).
Limitations may apply based on the specific plan implementation – for example, some employers may simply opt to make a Traditional IRA (not a 401(k)) available for direct deposit, but the total contributions and the tax withholding rules are different in those instances.
Qualified vs Non-Qualified Retirement Plans
Retirement plans are classified as either qualified or non-qualified. Broadly speaking, qualified plans meet ERISA guidelines and are eligible for tax benefits and government protection, while non-qualified plans do not meet ERISA criteria and are not eligible for tax-deferral benefits.
401(k) plans, 403(b) plans, and profit-share plans all fall under the umbrella of qualified retirement plans. Under this kind of plan, employees choose a certain percentage of their income to contribute to the plan, tax-free, and optionally matched by employers.
Non-qualified retirement plans include deferred-compensation plans and executive bonus plans. Employee savings under these plans aren’t eligible for tax benefits. Typically, companies offer non-qualified retirement plans as part of a benefits package for highly compensated employees, such as senior officers or management. These plans do not need to be offered to all employees and do not have contribution limits. As an employer, any matching contributions you make to a non-qualified plan will not be tax deductible.
State-Mandated Retirement Plans
In an effort to encourage retirement savings and improve financial security, several states have passed or are in the process of implementing legislation mandating that employers provide retirement savings opportunities for their employees.
So far 13 states have passed legislation and several more are considering it. The requirements can vary from state to state, so it’s important to understand what is required in each state where your employees live.
In most instances, employers may choose to either enroll employees in their own employer-sponsored plan or in a state-sponsored program. While state-sponsored plans offer low-cost solutions with less fiduciary responsibilities, employers are still obligated to fulfill administrative and reporting requirements.
Employer Matching Contributions for Retirement Savings Plans
Employers have the option to match some or part of their employees’ retirement savings contributions. It’s important to keep in mind that there is a contribution limit and a deduction limit on employer matching.
For defined benefits plans in 2022, an employer’s contribution cannot exceed the lesser of the participant’s total salary or $61,000. By contributing to employee retirement savings, employers can enjoy two tax benefits: deducting the amount that they contribute (up to a certain deduction limit, which depends on the type of plan you offer) and not paying FICA taxes on the 401(k)-matching contribution. In essence, the total cash consequence of employers contributing to their employees’ 401(k) will be less than if it were a simple cash bonus.
While you are not legally obligated to provide contribution matching as an employer, doing so incurs benefits both for employees and for your business. Employees gain additional tax-deferred income through this match into their 401(k); employers can deduct contributions from their corporate tax returns, up to the amount of 25% of the annual compensation paid.
Joseph Cravotta, Senior Retirement Plan Consultant at HB Retirement, points out that contribution matching can help some people reach a comfortable retirement who might otherwise have struggled to save enough:
“While individual situations vary greatly, a general rule of thumb is most individuals will need to save somewhere between 12-15% of their income to finance a comfortable retirement. Since this includes both employee deferrals and company contributions, company match can be a significant contributor to helping individuals save enough. We encourage employers to think about those numbers as we are helping them design their plan and structure their match.”
If your company does decide to set up employer contributions, there is some due diligence to attend to. For example, businesses must pass an IRS-mandated non-discrimination test to ensure highly compensated employees do no benefit disproportionately from employer matching. Employers do not need to pay FICA or Medicare taxes on employer matches into a 401(k), as long as the plan passes the discrimination testing.
Why Employers Offer Contribution Matching
In addition to tax deduction opportunities, matching retirement savings can have several advantages for employers. A significant matching contribution can allow you to attract and retain talent by providing a meaningful financial investment without risk to the employee. Recall that retirement savings are the #1 most desired employee benefit. Given the choice between two competitive offers, a generous matching contribution may just tip the scales in favor of one employer over another.
By matching contributions, employers can also play a role in incentivizing employees to save for the long-term goal of retirement, which we know to be a critical aspect of financial well-being. A common recommendation from financial advisors is for employees to contribute the max allowable amount to 401(k), or if that’s not possible, to strive to contribute as much as possible to take advantage of employer matching.
Partial Matching vs Full Matching
As an employer, you have the option to choose if and how to match employee contributions.
With partial matching, you agree to match a portion of the amount that an employee contributes. For example, you could match 25%, 50% or 75% of an employee’s contributions, up to a fixed percentage of their salary.
With full matching, you agree to match an employee’s contributions dollar for dollar. This means that if an employee contributes 1%, 2% or 8% of their salary, you’ll also contribute the same percentage.
In both cases, the amount you contribute will be capped by your employer contribution limit, as well as the employee’s overall contribution limit.
Finally, when evaluating different employer contribution schemes, consider financial equity as another important factor – especially with diversity, inclusion, and equity becoming a corporate priority.
401(k) Eligibility Period and Vesting Schedules
Employers may choose to restrict access to their retirement program until an employee has stayed with the company for a pre-determined eligibility period that’s applied plan-wide. This could be 30 days, 60 days or even a year. Typically, this eligibility period aligns with healthcare plan eligibility as well to make benefit communications easier, but may not always be the case.
Some employers choose to have a vesting schedule tied to their matching contributions, meaning employers must be employed for a minimum amount of time in order to be eligible to receive all or a portion of their matched contributions.
If an employee leaves or is terminated prior to their vesting period, they may forfeit their employer-matched contributions, however, their personal contributions and any interest earned will not be impacted.
Some employers also choose to increase matching contributions based on the number of years of employment. For example, employer matching could increase from 1% in the first year to 4% in the third year and 6% in the 10th year.
Upcoming Changes to US Retirement Plans
In light of the significant shortfall between the cost of retirement and actual savings upon retirement age, US congress has put retirement savings programs on the agenda, with broad bipartisan support in 2022. While the final outcome is yet to be determined, employers should anticipate new legislation to impact their retirement benefits plans in the near future.
Two key acts of legislation are currently being proposed. The House of Representatives passed the Securing a Strong Retirement (SECURE) Act on March 29, 2022. The Senate’s Health, Education, Labor, and Pensions (HELP) Committee approved its version already, and the Retirement Improvement and Savings Enhancement to Supplement Health Investments for the Nest Egg (RISE & SHINE) Act, will be voted on in the Senate later this year.
It’s plausible that the House and Senate will reconcile the differences between these Acts and pass new legislation later this year.
SECURE Act 2.0
Building on the SECURE Act of 2019, the new SECURE Act proposes several legislative changes designed to promote retirement savings. Among these changes are:
- Automatic enrollment in retirement plans for new employees, and automatic contribution escalations year over year
- Increases to some retirement savings limits
- New tax incentives for small businesses offering retirement plans
- More flexible savings options for individuals 60+
- Provisions to enable employers to offer small incentives to employees to save for retirement
- Withdraw up to $1,000 once without any penalty fee in the case of emergency
RISE & SHINE Act
The RISE & SHINE Act builds on SECURE 2.0, with several differences. Notable among these differences is the inclusion of the Emergency Savings Act of 2022.
The Emergency Savings Act would enable 401(k) plans to include emergency savings accounts. Participants could make pre-tax contributions to their emergency savings, and employers could match those contributions, with a combined contribution limit of $2,500. This legislation would enable employees to make withdrawals at any time, without paying penalties and needing to meet the requirements of hardship withdrawals.
What Type of Retirement Plan Should You Choose?
The best retirement savings plans offer equitable access to retirement benefits, as well as strong financial incentives to support hiring and retention goals.
Once you’ve identified which categories of retirement plans your company is eligible for, you must decide which plan or plans you’d like to offer to employees.
Consider how you can support all of your employees, including part-time or lower-income employees. With so many Americans falling short of their retirement goals or failing to save at all, a retirement savings plan can make a significant impact on your workforce.
An effective way to understand what employees want and need from a retirement plan is to ask them directly through an employee benefits survey. This may help you identify gaps among certain demographics or income levels within your company.
How to Implement an Employer-Sponsored Retirement Plan
To implement your retirement savings plan the IRS recommends considering each of these steps:
- Choosing: Select a retirement plan that will allow you to support your employee’s retirement savings goals while providing tax deductions for your business.
- Establishing: Once you’ve chosen an option, you must meet the administrative requirements for the plan, which may include establishing a written plan, choosing investment assets and notifying employees.
- Operating: As a plan operator, you must stay up to date on all legal administrative requirements including managing the plan’s assets, regularly providing plan information to employees and distributing benefits.
- Terminating: If your plan does not meet the needs of your beneficiaries or your business, you may opt to terminate it and replace it with a new one.
How 401(k) Loans and Early Withdrawals Impact Employers and Employees
While retirement savings are of course earmarked for retirement, it is not uncommon for employees to need to access these funds early.
In Sunny Day Fund’s 2022 Financial Well-Being survey, we found that 22% of respondents had dipped into their retirement savings in 2022. Unfortunately, early withdrawals from retirement savings accounts can incur steep penalties. Let’s look at the consequences of employees drawing down on both 401(k)s and hardship loans in order:
Most 401(k) plans allow employees to borrow money from their savings. In effect, the employee is borrowing money from their future selves. Repayments are made automatically from paychecks over time at market interest rates. There’s a maximum limit on how much you can borrow: either $50,000 or half the total vested amount, whichever is lesser.
There are pros and cons to employees taking 401(k) loans. On the positive side, there’s no early withdrawal penalty, and the interest you pay is paid to yourself rather than a third party. On the negative side, you’ll be making repayments with already–taxed dollars which will be taxed a second time when you eventually withdraw your retirement savings. And of course, the retirement savings nest egg won’t grow without continuing contributions and if it isn’t being invested and added to each month. In case the loan is never fully paid back, there can be penalties and tax consequences as well.
If an employee suffers a real financial emergency, they may be eligible for a hardship loan. The IRS has guidelines defining the type of financial emergency that warrants a hardship loan, including events such as medical emergencies and mortgage foreclosures.
Typically a hardship withdrawal before age 59½ will incur a 10% penalty for employees, though there are exceptions in the case of hardships such as death, disability or disaster. Even if tax penalties are not incurred, employees who make early withdrawals compromise their ability to reach their retirement goals because of the taxes due on withdrawn funds, and the hit to total retirement savings.
That’s why hardship loans are often (rightly) considered as a last resort to cover unexpected expenses.
What Employers Should Keep in Mind About Loans
Offering 401(k) loans to your team is often considered a way to encourage participation in retirement savings plans. In these situations, employers are telling teams that their retirement savings can function as both nest egg and emergency savings mechanism
However, there are operational inefficiencies involved in planning to have workers rely on 401(k) loans to cover emergency expenses. Most notable are the administrative tasks HR teams need to carry out when agreeing to 401(k) loans:
- Enforcing repayment schedules to remain IRS compliant
- Notifying employees about missed repayments
- Managing leaves of absence and repayment deferrals
- Amortizing the loan after a leave of absence
- Reporting compliance, including loan monitoring reports, repayment schedules, and delinquent loan reports
Offering an emergency savings plan in tandem with retirement savings can be a better alternative than asking employees to rely on retirement loans to cover financial emergencies.
How Emergency Savings Protect Retirement Plans
Workers who have access to emergency savings are less likely to dip into retirement plans in emergencies. A 2021 study by Aspen Financial Security Program, Morningstar, DCIIA and NORC found that households with $1,000 in emergency savings were half a likely to request a hardship or 401(k) loan than households without an emergency cushion. This implies that emergency savings have significant protective potential for long-term financial well-being.
For employees, there are clear benefits to having emergency savings as an additional benefit to retirement savings. Emergency savings plans do not fall under ERISA, so there are no penalties for withdrawal and no contribution limits. Emergency savings also reduce the frequency of retirement withdrawals, thereby increasing long-term financial stability.
For employers, there’s less administrative work involved in withdrawals from emergency savings plans, and the employee can manage withdrawals themselves.
Jospeh Cravotta from HB Retirement agrees that emergency savings are a high impact way to avoid the disadvantages of while 401(k) and hardship loans:
“Despite educating employees on the disadvantages of 401(k) loans and hardship withdrawals, we find they are sometimes the only financial resource individuals have available. Unfortunately, these distributions can significantly reduce the long-term potential for an employee’s retirement plan. We see emergency savings programs being a powerful complement to the retirement plan by providing a vehicle to help individuals build a financial foundation and limit using retirement assets for short term needs.”
Sunny Day Fund’s Emergency Savings Plans are designed to make it easy for employers to provide savings benefits to all employees, including lower-income earners who are most likely to need to access their retirement savings in an emergency. This benefit can contribute to overall workplace morale and retention, providing substantial benefits for employers.
Getting Started with Retirement Savings
Now that you understand the basics, it’s time to think about how to use retirement savings to address the needs of your workforce. We know that employee benefits can make a significant impact on hiring, retention and employee satisfaction, and with retirement saving plans ranking at the top employees’ priority lists, we believe they should have a place on every employer’s list too.
If you’re interested in protecting your workers’ retirement assets and supporting emergency savings, reach out to Sunny Day Fund! Our team is always happy to talk.