The majority of private-sector employers offer defined contribution (i.e. 401(k), 403(b), 457) plans that place the onus of contributing and investing for retirement on the employee. A defined contribution plan does not guarantee a set payout at retirement. The employer is not required to contribute to the funding of the retirement for their employees by making contributions to their accounts. The availability of a defined contribution plan ends up being far more cost-effective for the employer. However, as an added benefit to assist employees by sharing the burden of saving for retirement many defined contribution plans offer employer matching contributions.
The so-called “company match” is used as a key selling point for employers to attract new employees and retain existing employees. A certain percentage of a firm’s employees must participate for a plan to be considered legitimate by the IRS. Typically, the company’s contribution level is tiered: For example, a generous match might include a dollar-for-dollar match on the first 3% of the employee’s deposit, then 50 cents on each dollar of the next 3%, up to 6% of employee contributions in total.
In these challenging economic times caused by the fallout from the pandemic many employers are eliminating the generous company match to an employees’ contributions into their defined contribution plan. As employers attempt to cut costs, eliminating the employer match is an obvious temporary option compared to other more drastic measures such as layoffs, furloughs, and downsizing. When an employer match is temporarily, or permanently eliminated then employees should be looking for ways to replace the matching contributions and other options for retirement savings.
There are several options including the employee increasing their contributions by the same percent as the company match to replace the lower contribution amounts. The higher contributions by the employee will have the added benefit of reducing their taxable income in the current year, if made to a traditional defined contribution plan. The ability to make additional contributions is only an option if the employee is not already contributing the maximum amount allowed to their defined contribution retirement plan.
A second option available to most employees would be to contribute up to $6,000, or $7,000 if you are at least age 50, to a Roth IRA. If you have other funds available for contributions to retirement plans, then contribute that money to your company retirement plan. The reasoning behind this approach is that tax rates are projected by most experts to be higher in the future when the retirement funds in traditional IRAs, or traditional retirement plans are withdrawn and taxes due on them. Therefore, contributions should first be made to a Roth IRA for most people, so the amounts are taxed now at lower rates and withdrawn later when they are not subject to the higher tax rates. In addition, if the funds are held for more than 5 years in a Roth IRA, the earnings as well as the original contributions can be withdrawn tax and penalty free once the owner is over 59 ½ years old.
A third option for maintaining the same level of total retirement funding contributions when the employer match is eliminated would be to contribute the same amount to a taxable account which would result in the employee being taxed at a lower capital gains rate when they sell the underlying investments to use for retirement. The option does allow more flexibility, so if the individual is disciplined to make sure the funds are held for retirement then it may be a good option. The down side to the taxable account contributions is that nobody can predict if capital gain tax rates will remain lower than ordinary income tax rates in the future, so the benefit of the flexibility may be more than offset by higher taxes than anticipated in the future.
A fourth option is to take the Roth concept a step further, if your employer plan offers a Roth option related to your employer retirement plan, then it is recommended for most employees to take advantage and contribute all of their retirement funds to the Roth option versus the traditional defined contribution plan option (i.e. Roth 401(k) vs. Traditional 401(k)). The reduction in the employees’ overall retirement plan savings from eliminating the company match will be partially offset because the earnings on the Roth option will not be taxed in the future when withdrawn during retirement. In the long run contributing to the Roth versus the regular retirement plan will likely result in a better outcome. You will not have the pretax contributions to reduce your current income taxes, but if tax rates increase, or stay the same, in the long run using the Roth option will result in higher after-tax savings. If you are not completely sold on using the Roth option of your employer retirement plan for all of your current year contributions then you can invest a portion in the traditional option and a portion in the Roth option.
The bottom line is that employees should make every attempt to look for options to replace the temporary, or permanent elimination of the company match to ensure their retirement goals are achieved.
If you need immediate advice, confirmation, or a second opinion about any of the topics discussed in this article, please reach out to Lydford Financial PLLC for a free one-hour consultation now through October 31, 2020. We would also be happy to help you with a comprehensive financial plan that can prepare you for the next strain on the financial system and your personal financial situation.