Alternatives to the Traditional 401(k)
First introduced in 1978, 401(k) plans are now America’s most popular choice for employer-sponsored retirement plans. However, just because traditional 401(k)s are popular doesn’t mean they are the best option for all companies.
A traditional 401(k) allows employers to enjoy tax credits and write-offs while employees can use pretax money to fund their accounts. This lowers taxable income and lets funds grow tax free until the employee retires — when, hopefully, they’re in a lower tax bracket. Employer contributions help employees’ retirement savings grow even faster.
Here are a few options that might be good for your company.
Pooled Employer Plans
The Setting Every Community Up for Retirement Enhancement Act of 2019 (SECURE Act) became law in 2019. On Jan. 1, 2021, the SECURE Act established a new type of multiple employer plan. Pooled Employer Plans (PEPs) allow sponsors to pool their retirement resources with those of other employers.
The operation of a PEP is handled by third-party administrators known as pooled plan providers (PPPs). PPPs must register with the IRS and Department of Labor and meet certain criteria as eligible providers.
The difference between 401(k) multiple employer plans (MEPs) and PEPS is MEPs are available to businesses within a similar industry (food service, construction, etc.). PEPs can include employers of every size and from various industries.
Smaller employers are expected to benefit the most from PEPs. Benefits include:
- Spending less time on the day-to-day administrative tasks required under traditional plan sponsorship.
- Fewer legal obligations — the PPP serves as the administrator and has fiduciary responsibility.
- Better pricing — by pooling assets, participants increase their access to improved pricing and diverse investment products.
The downside of a PEP is they are still new and employers may be hesitant to embrace them. Plus, MEPs with their industry-specific benefits and sometimes greater flexibility may still be more attractive to many employers.
A 403(b) plan is a retirement account for employees at public schools and tax-exempt organizations. These include teachers, school administrators, professors, government employees, nurses, doctors and librarians.
Both 401(k) and 403(b) plans share these similarities:
- Employees may be eligible for matching contributions. However, if it is a non-ERISA 403(b) plan, there can be no employer contributions and non-ERISA plans may lack the same level of protection from creditors as plans that require ERISA compliance.
- Contributions are limited to $19,500 in 2021. The combination of employee and employer contributions is limited to the lesser of $58,000 in 2021 or 100% of the employee’s most recent annual salary.
- Earnings are tax-deferred until withdrawn.
- Roth options are available.
- Participants must reach age 59½ to withdraw funds without incurring an early withdrawal penalty.
- There is a $6,500 catch-up contribution allowed for those 50 and older in 2021.
- Many 403(b) plans vest funds over a shorter period than 401(k)s and some even allow immediate vesting.
- Employees who have 15 or more years of service with certain nonprofits or government agencies may be able to make additional catch-up contributions to a 403(b) plan.
On the downside, a 403(b) may offer narrower investment choices than other types of plans.
Defined Benefit Pension Plans
Defined benefit plans provide a fixed, pre-established benefit for retiring employees. For many years employers used defined pension plans to entice employees to stay their entire careers.
The advantage to employees of a pension plan is that it provides predictable benefits, and it’s not dependent on asset returns. The employer makes most, if not all, of the contributions.
To an employer the advantage is that they can deduct contributions, and, since they generally contribute more each year, they get to deduct more each year.
However, defined benefit plans often are more complex and more costly to establish and maintain than other plans. Plus, the employer cannot retroactively decrease benefits if funding for the year is tight.
These plans have lost favor because the burden of providing the guaranteed benefit falls on the employer. Primarily to avoid the uncertainty of funding specified benefits with unknowable and typically ever-increasing costs, employers have shifted to defined contribution plans, like a 401(k). The amount saved depends on the employee. Employers can contribute funds, but usually less than with a pension plan.
Pension plans can be offered by a business of any size — even if the business offers other retirement plans.
Employee Stock Ownership Plan
To establish an Employee Stock Ownership Plan (ESOP), an employer sets up a trust fund for employees and contributes either cash to buy company stock, contributes shares directly to the plan, or has the plan borrow money to buy shares. If the plan borrows money, the company makes tax-deductible contributions to the plan so it can repay the loan.
Employees don’t pay tax on contributions until they receive the stock when they leave or retire. They can either sell it on the market or back to the company.
Companies with ESOPs and other employee ownership plans account for well over half of Fortune Magazine’s “100 Best Companies to Work for in America” list year every year.
The biggest advantage of an ESOP is it creates a strong ownership culture, while producing the potential for the company to gain significant tax advantages.
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