Impact of Workplace Retirement Plans

Gone are the days when you could rely on a simple pension plan and Social Security benefits to sustain you during the golden years of your life. Today, pensions have become a rare benefit, and Social Security is not sufficient to maintain your lifestyle in retirement. Hence, it is important that you save for your retirement in alternative modes, such as workplace retirement plans.

Your workplace retirement plan is a powerful way to ensure your future financial security. Experts estimate that most of the retirement income in the U.S. will come from funds saved through workplace retirement plans. These plans are also commonly known as savings plans, retirement plans, etc. Workplace retirement plans offer a valuable benefit that can potentially impact your present and future life. However, given the various retirement plans, their eligibility, and other rules, the IRS (Internal Revenue Service) will allow you to only invest in a few of these workplace retirement plans.

Hence, it is wise to understand each workplace retirement plan holistically, evaluate its advantages and limitations, determine its overall impact, and accordingly, make an informed decision regarding which plan to invest in.

Here is what you should know about the different workplace retirement plans and their potential impact on your future:

Types of workplace retirement plans

• 401(k) plans:
  This is one of the most popular retirement savings plans in the U.S. This plan is offered as an employee benefit, where you can contribute a part of your pre-tax income that is further invested in tax-deferred investments. This in turn, reduces your taxable income for the current year, allowing you to pay fewer taxes now and save more. For example, if you contribute $4,000 in your 401(k) account and earn $70,000 in all, the IRS will levy taxes on $66,000 only. Further, the investments you make in your 401(k) account grow tax-deferred until you withdraw the funds during retirement. In case you take a drawing from your 401(k) plan before the permissible age of 59.5, the IRS will charge a penalty of 10%, while the withdrawal sum will also be subject to ordinary federal and state income tax rates. However, in some specific cases like a financial emergency, etc., the IRS permits you to take penalty-free withdrawals before the age of 59.5.
  Alternatively, your employer can also choose to match your contribution, usually up to 6%. But in most cases, you can only withdraw this amount from your account, after a specific period has elapsed. This restriction does not apply to your own 401(k) balance. That said, investment options in your 401(k) account will be restricted, and you would be liable to pay a management or administrative charge on top. Further, the IRS limits the amount you can contribute to your 401(k). For 2021, you can save up to $19,500 in your 401(k), or $26,000 if you are above the age of 50. These limits remain unchanged from 2020. Your employer might offer you variations of a 401(k) account such as 403(b), which is primarily for a non-profit organization employee or an educator. Government employees get access to a 457(b) plan.Impact of a 401(k) on your future

  Participating in a 401(k) or a related plan is a wise financial move for your future security, primarily because of the following reasons:

  • Tax breaks so earning can grow tax deferred till retirement in a 401(k) plan: The most significant impact of your 401(k) plan is the tax break. These plans require you to make pre-tax contributions. This lowers your taxable income for the year and it helps to defer your tax burden until withdrawals in retirement when you probably would be in a lower tax bracket. Further, to magnify the tax benefit, your 401(k) earnings grow tax-deferred until withdrawn. This implies that dividends and capital gains on your 401(k) funds are not subject to taxes until you begin taking drawings from your account.
  • Employer-match contributions in a 401(k) plan: In most cases, employers offer to match your contributions in a 401(k) plan. Moreover, some companies also contribute a portion of their profit to your plan. If you get any or both of these benefits in your 401(k) plan, you get access to free money, which helps in the accumulation of a greater corpus for your future. Some employers match 50% of your contribution up to 6% while others go for a dollar-to-dollar match for the first 6%.
  • Higher contribution limits to your 401(k) plan: As compared to an IRA (Individual Retirement Account), a 401(k) allows you to contribute a much higher sum. As specified, for 2021, you can contribute up to $19,500 if you are younger than 50 years. However, for those above the age of 50, the IRS permits a catch-up contribution of up to $6,500. If your employer also contributes to your account, you have a combined upper cap of $58,000 or $64,500 (including the catch-up contribution). This helps you save a much large amount for the financial security of your retirement years.
  • Contributions beyond the age of 72 in a 401(k) plan: Unlike some retirement accounts, 401(k) plans allow you to contribute beyond the age of 72, as long as you are still working. In other accounts, you cannot contribute any money up to the age of 72, irrespective of whether you are employed or not. This implies that the money you deposited on a pre-tax basis is taxed at your current rate instead, while you are still earning and your tax bracket is high as compared to retirement. Further, you do not have to take the RMDs (Required Minimum Distributions) from your 401(k) plan if you are still working and own less than 5% of the company you work for.
  • Protection from creditors to protect your 401(k) balance: A 401(k) plan is set up under the Employee Retirement Income Security Act (ERISA), whose accounts are usually safeguarded from creditors. This ensures your financial security even in some of the most critical financial situations. Further, even the IRS cannot claim your 401(k) balance as these accounts legally belong to your employer. Your plan administrator reserves the full right to refuse to comply with an IRS lien.
• Roth 401(k):
  A Roth 401(k) is an ideal workplace retirement account that combines the best features of a 401(k) plan and an IRA (Individual Retirement Account). In a Roth 401(k), you make after-tax contributions instead of pre-tax money like a 401(k) plan. This implies that you pay taxes in the present and owe no further taxes in the future, even on withdrawal of funds, provided they are qualified distributions. Roth 401(k) plans have two qualification parameters. First, you must hold the account for at least five years before taking any withdrawals. Second, you should be at least 59.5 years old at the time of withdrawal. However, in the case of permanent disability, the distributions taken from a Roth 401(k) are considered qualified. For any withdrawals that do not meet the set criteria, the IRS levies a penalty of 10% on the sum withdrawn. That said, just like a traditional 401(k) plan, your earnings in a Roth 401(k) also grow tax-deferred. Another advantage of investing in this workplace retirement plan is that there is no income limit like a Roth IRA. Your annual contribution limits are the same as a 401(k) with the difference of after-tax investments.
  Impact of a Roth 401(k) on your future:
  Participating in a Roth 401(k) can positively impact your future financial security because:
  • Low future taxes in a Roth 401(k): When you choose to invest in a Roth 401(k), you pay taxes on your contribution in the present while eliminating any future taxes. This can work to your advantage if you expect yourself to be in a higher tax bracket during retirement. For example, if you are paying fewer taxes in the present, it can be wiser to pay tax now and evade the higher tax burden in the future. Even though your overall income in retirement may decrease, the likely upsurge in the future tax rate could subject you to a higher tax bracket.
  • More specific future financial planning to secure the non-working years of your life in a Roth 401(k): A Roth 401(k) reduces your current paycheck because your contributions in this plan are tax-adjusted. This enables you to be certain of your tax liabilities, and accordingly, make a financial plan to secure the non-working years of your life. When you defer your tax liabilities, you are undertaking an element of risk, which is not an ideal strategy for a safe retirement.
  • Better liquidity of funds in a Roth 401(k) account: A Roth 401(k) allows you to borrow up to 50% of your account balance or $50,000 (whichever is lower). However, you have to understand and adhere to the loan terms, or the distributions will be taxable as ordinary withdrawals and might incur a penalty if taken before the age of 59.5.
  • More flexibility to make contributions in a Roth 401(k): A Roth 401(k) allows you to make contributions even if you earn a significantly higher income. This is not the case in a Roth IRA that has strict income eligibility restrictions. Moreover, you can convert your Roth 401(k) into a Roth IRA with minimum complications and paperwork. The objective to undertake the conversion is to avoid the mandate of RMDs.

  Apart from these two most popular workplace retirement plans, there are other options, such as:

• SIMPLE IRA:
  SIMPLE (The Savings Incentive Match for Employees) IRA is a workplace retirement plan that is available for small businesses with less than 100 employees. The plan works similarly to a traditional 401(k) workplace plan. The contributions are made from pre-tax dollars and the funds grow tax-deferred until retirement withdrawals. In a SIMPLE IRA, any distributions taken within two years of the SIMPLE IRA plan opening or before the age of 59.5 will attract a penalty from the IRS. Further, you cannot borrow from a SIMPLE IRA the way you can from a 401(k). Additionally, since a SIMPLE IRA is operationally the same as a 401(k) plan, its impact on your future is also similar.
• SEP IRA:
  A Simplified Employment Pension (SEP) permits a self-employed individual with no employees to contribute a part of the income to their retirement account. You can take advantage of this workplace retirement plan if you run your own business and have no employees. You can deduct the contribution from your annual taxable income. As of 2021, you are allowed to contribute not more than $58,000 or 25% of your income, whichever is lower.

To sum it up

If you can save more for retirement and have exhausted your workplace retirement plans, you can turn to an IRA or a Roth IRA for more savings and tax-benefits. That said, access to a workplace/employer-based retirement plan helps you build adequate economic security for your future. This is one strong reason fuelling the growth of workplace retirement plans in the U.S. As per a recent survey, 90% of eligible employees held an account balance in 2019, and 87.3% made contributions to their workplace retirement plan, pushing the overall average savings rate to 12.9% in 2019. Therefore, to understand all your workplace retirement plan options and choose one that best suits your needs, it is best to consult a professional financial advisor to make an informed decision and safeguard those golden years of your life.