Assessing Employer-Sponsored Retirement Benefits

Understanding the retirement benefits offered by your employer is an essential step in financial planning. These benefits can significantly contribute to your financial security in retirement. The common types of employer-sponsored retirement benefits include 401(k) plans, pension plans, profit-sharing plans, and employee stock ownership plans.

401(k)

A 401(k) is a retirement savings plan sponsored by an employer. It alloys an employee to automatically deduct a percentage of their paycheck that is set aside and invested according to the plan. Named after a section of the Internal Revenue Code, 401(k) plans have grown in popularity over the years as a key retirement tool, partly due to their tax advantages and flexible contribution limits.

401(k)

A 401(K) is a tax-advantaged, defined-contribution retirement account offered by many employers.

There are two types of 401(k) plans – traditional 401(k) plans and Roth 401(k) plans.

traditional vs Roth 401(k) plans

Traditional 401(k)

 

In a traditional 401(k) contributions are removed before taxes are applied, reducing the employee’s taxable income. Meaning, employees contribute a percentage of their pre-tax salary to their traditional 401(k) plan. However, when you withdraw from your traditional 401(k) account in retirement, the contributions and investment earnings are taxed as ordinary income.

 

Roth 401(k)

 

Roth 401(k) contributions are made with after-tax dollars, but withdrawals in retirement are tax-free. However, if contributions are removed before the age of [latex]59 \frac{1}{2}[/latex] the contributions will be taxed. It is important to note that contributions matched by your employer will be taxed when you collect from the plan.

You have probably heard of another retirement plan known as an IRA. It is important to realize a 401(k) and an IRA are different. The main difference between a 401(k) and an IRA is that employers offer a 401(k), while individual retirement accounts (IRAs) are opened by an individual on their own. IRAs do not offer the benefit of employer matching and have different contribution limits than 401(k)s do. We will explore IRAs more on the next page.

An employee can contribute a percentage of their salary to a 401(k) plan up to a limit set by the IRS. As of 2023, the current limit to 401(k) contributions is [latex]$22,500[/latex] a year for those under the age of [latex]50[/latex]. Some 401(k) plans allow for individuals over the age of [latex]50[/latex] to make annual catch-up contributions up to [latex]$7,500[/latex] a year more than what is typically allowed.

Many employers match a portion of the employee’s contribution, typically around [latex]3-6\%[/latex] of the employee’s salary. This employer match is essentially “free money” and can significantly boost retirement savings over time. The specifics of matching contributions vary by employer. Many 401(k) plans have a vesting schedule, which dictates when employer contributions to the plan become the employee’s property. It’s important for employees to understand their plan’s vesting schedule, as leaving a job before fully vested could result in a loss of some or all of the employer contributions.

Mahala signs up for her employer-based 401(k). The employer matches any 401(k) contribution up to [latex]6\%[/latex] of the employee salary. Mahala’s annual salary is [latex]$51,600[/latex].

1. What is the most money that Mahala can deposit that will be fully matched by the company?
2. How much total will be deposited into Mahala’s account if she deposits the full [latex]6\%[/latex]?

Show Solution

1. The employer will match up to [latex]6\%[/latex] of any employee’s salary. [latex]6\%[/latex] of Mahala’s salary is [latex]0.06\times$51,600=$3,096[/latex]. So Mahala can deposit up to [latex]$3,096[/latex] and receive that amount in matching funds in her account.
2. Mahala’s contribution plus the company’s contribution is [latex]$3,096+$3,096=$6,192[/latex], which is the total that is deposited into Mahala’s account.

401(k) plans typically offer a selection of investment options, usually mutual funds. These might include stock funds, bond funds, money market funds, or target-date funds. Employees should carefully select their investments based on their risk tolerance and time horizon to retirement.

Early withdrawals from a 401(k) before the age of [latex]59 \frac{1}{2}[/latex] are subject to a [latex]10\%[/latex] penalty in addition to income taxes, with certain exceptions. Some 401(k) plans also allow for loans to be taken out against the 401(k) balance, but this is generally discouraged as it can hinder the growth of retirement savings.

Remember, it’s essential to consult with a financial advisor to understand how a 401(k) fits into your overall retirement planning strategy. Your 401(k) is an important piece of the puzzle, but it should be considered in the context of your other savings, expected Social Security benefits, and overall retirement goals.

Some employers offer 403(b) and 457 plans instead of 401(k) plans. These plans are similar to 401(k) plans but are offered by specific types of employers. 403(b) plans are for employees of certain public schools, tax-exempt organizations, and certain ministers. 457 plans are for employees of state and local governments and some tax-exempt organizations.

Pension Plans

A pension plan is a type of retirement plan where an employer sets aside funds for an employee’s future retirement income. Pension plans, also known as defined benefit plans, promise a specified monthly benefit at retirement, typically based on the employee’s years of service, age, and earnings history.

pension plan

A pension plan is an employer-provided financial arrangement where a pool of funds is set aside and then used to offer fixed income to employees upon retirement.

Unlike 401(k) plans where the employee makes the majority of the contributions, with pension plans, it’s the employer’s responsibility to make contributions to the pension fund. The employer manages the fund’s investments and bears the risk of those investments.

Similar to 401(k) plans, pension plans also have vesting schedules. An employee may have to work a certain number of years before they earn a right to their pension at retirement. This schedule is set by the employer.

Pension benefits are subject to taxation. Once a retiree starts receiving their pension, the payments are treated as income for tax purposes.

Pension plans have become less common over the years, particularly in the private sector. This is partly due to the financial risk they place on employers and their costliness. Many employers have moved towards defined contribution plans, like 401(k)s, where the investment risk is borne by the employee.

Having a pension can significantly impact retirement planning. Because it provides a guaranteed income stream in retirement, those with a pension may need to save less in individual retirement accounts or other personal savings. However, it’s crucial not to rely solely on a pension for retirement income. As with all aspects of retirement planning, it’s advisable to speak with a financial advisor to understand how a pension fits into your overall retirement strategy.

Shared Success: Employee Stock Ownership Plans (ESOPs) and Profit-Sharing Plans

Some employers offer retirement plans that provide employees with a more direct stake in their company’s success.

employee stock ownership plans (ESOPs) and profit-sharing plans

Employee Stock Ownership Plans (ESOPs)

 

ESOPs are a type of retirement plan in which the company contributes its stock to the plan for the benefit of the company’s employees. This allows employees to own a portion of the company they work for.

 

Profit-Sharing Plans

 

In a profit-sharing plan, employers share a portion of company profits with employees by contributing to their retirement savings. The amount contributed varies from year to year based on the company’s profitability. The contributions by the employer are placed into individual accounts for the employees. These contributions are then invested, and the returns on the investment are credited to the employees’ account.

Funds in ESOPs and profit-sharing plans are not taxed until the employee withdraws them. It’s important to note that these plans often come with “vesting” requirements. Vesting refers to the amount of time an employee must work for a company before gaining access to the employer’s contributions to the plan.

Both Profit-Sharing Plans and ESOPs provide employees with a beneficial way to share in the company’s success, while simultaneously creating a secure foundation for their retirement. However, as with any investment, they carry risk and employees should carefully consider their individual financial situation and retirement goals before participating.