Labor Day is around the corner. The American labor movement brought us Labor Day, the weekend, employer-sponsored health coverage, and the right to retire. In the late 1800s, industrialization dramatically increased people’s lifespans. Workers were living far beyond 35 years and needed support after a life of physically demanding jobs. Labor Day and retirement are linked because they are both part of the long history of workers’ rights activism.
Employer-sponsored retirement programs evolved over the years and can still vary. In general, an employer-sponsored retirement plan provides valuable employee and employer benefits. These plans include automatic paycheck deposits, tax breaks, and specific employer matching of employee contributions.
Two Categories of Employer-Sponsored Retirement Plans
1. Defined Benefit Plan
A defined benefit plan provides a guaranteed monthly benefit amount at retirement. These plans are also known as pensions and require investment managers to handle accounts. As the employer, you take on the risk of this plan type.
The 1978 Revenue Act gave employees a new tax-advantaged way to save for retirement through 401(k)s. Most companies have replaced pension plans with 401(k) plans due to the high ongoing liabilities involved in managing pension plans. Today, only 4% of employers offer pensions, typically in industries with a strong union presence, such as the airline and auto.
2. Defined Contribution Plan
A defined contribution plan does not offer a guaranteed payout at retirement. A 401(k) is an example of a defined contribution plan. These plans include contributions from both employer and employee, often at a set percentage rate of an employee’s annual salary. The employee takes on the risk in this type of plan. The account’s overall value will change based on the value of investments. At the time of retirement, employees receive the account balance based upon contributions plus or minus gains and losses from investments.
Common Contribution Plans
1. 401(k) Plan
This is the most common type of employer-sponsored retirement plan. Most large to medium, for-profit businesses offer employees 401(k) plans. The employee is responsible for contributing pre-tax dollars from their paychecks, and many companies offer to match a certain percentage of employee contributions. Employees can select which investments their money goes towards and retain complete control of the account at the time of retirement.
The maximum annual employee contribution is $20,500 for the 2022 tax year. The combined employee and employer contributions cannot exceed $61,000 in 2022. Catch-up contributions for employees 50 or older is $6,500 or a 2022 maximum of $67,500. Total contributions cannot exceed 100% of an employee’s annual compensation.
When you withdraw funds from your 401(k), these distributions are taxed as ordinary income.
2. Roth 401(k) Plan
This plan is similar to the 401(k) with the same employee contribution limits. However, employees contribute after-tax dollars from their paychecks. Why would employees consider this option? Roth 401(k) plans may be a good option for young employees because they tend to be in a lower tax bracket in their earlier years of working. Therefore, their up-front tax deduction will be lower than the tax rate when they withdraw from a 401(k) later in life.
When you withdraw money during retirement from a Roth 401(k) plan, you will not pay tax as long you are over 59 ½ years old and have maintained money in the account for a minimum of 5 years.
3. 403(b) Plan
The 403(b) plan is virtually the same as a 401(k) plan but is designated for nonprofit organizations such as hospitals, public schools, churches, and other organizations. This plan allows participants to save money for retirement via payroll deductions before tax, and the employer can match part of the employee’s contribution. 403(b) plans may have fewer investment choices but tend to have faster vesting schedules.
When you withdraw money during retirement from a 403(b) plan, you will not pay taxes or penalties as long you are over 59 ½ years old.
4. SIMPLE Plan
SIMPLE (Savings Incentive Match Plan for Employees) is an individual retirement account (IRA) plan offered by smaller businesses. Employees can make pre-tax contributions to the plan. Employers must contribute to these accounts and have two options to make contributions. The first is to match the amounts employees make toward their own elective contribution up to 3% of the employee’s annual compensation. The second option is for the employer to make a flat 2% of wages (nonelective) contribution to all qualified employees, regardless of whether the employee makes any contributions.
According to Internal Revenue Service (IRS) regulations, only employers with fewer than 100 employees—and which do not offer other retirement plans—may establish a SIMPLE IRA. All employees who received $5,000 or more in compensation from an employer during any two previous calendar years and who are expected to receive $5,000 or more in compensation this year are eligible to participate in the employer’s SIMPLE IRA plan.
There are more details about these group retirement accounts. Allow PT Business solutions to assist you in finding the right employer-sponsored retirement plan for you.