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Understanding the Basics of an Employee Savings Plan

December 15, 2020 · 7 minute read

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Understanding the Basics of an Employee Savings Plan

An employee savings plan is a tax-advantaged investment plan offered by an employer. The employer may offer to match any contribution made by employees, who can later use the funds for long-term financial goals like retirement.

The saving process is simplified by the employer taking automated deductions from an individual’s paycheck before income tax is collected. Using an employee savings plan provides you with a number of benefits. You may be able to increase your retirement savings contributions while also saving on taxes.

What Is an Employee Savings Plan?

Some employers offer an employee savings plan to help employees invest for retirement and other long-term financial goals, like a down payment on a house. Leveraging an employee savings plan is one of the first steps to building a simple savings plan you can stick to.

Each employee chooses how much they want to contribute to the plan each month. That amount is then deducted from the employee’s paycheck each month. If paychecks are distributed biweekly, the contribution will likely be split up between the two.

The automated process can help make it easier to save, and employees generally have the option to change their contribution amount based on their needs and goals.

Employee Savings Plans Contributions are made on a pre-tax basis. That means the funds are transferred to your savings plan before taxes are taken from your paycheck. This allows account holders to save money while paying taxes on a smaller portion of your salary.

In some cases, your employer may offer a matching contribution to any funds you contribute to your employee savings plan. Usually, there is a match limit equivalent to a certain percentage of your salary.

For instance, imagine your employer matches your contributions up to 3% of your salary and you earn $75,000 a year. That amounts to $2,250.

As long as you contribute at least $2,250 to your plan, your employer will give you the same amount, for a total of $4,500—plus anything over that amount you decide to contribute.

Types of Employee Savings Plans

There are several types of employee savings plans you may have access to through your job.

Many organizations offer qualified defined contribution plans, which means it qualifies for pre-tax contributions and tax-deferred growth. Private companies offer these through 401(k) plans, while public or non-profit organizations generally offer 403(b) or 457(b) plans.

Another type of employee savings plan you may see is a health savings account (HSA). If you have a high-deductible health plan (HDHP), this plan lets you save money tax-free to pay for qualified medical costs that aren’t covered by insurance.

A profit-sharing plan is less common, but also helps you save for retirement. Employees own shares of the company and receive distributions from the company either quarterly or annually. However, as an employee, you cannot add your own contribution to a profit-sharing plan.

A defined benefits plan, also known as a pension plan, is another type of employer sponsored plan. In this type of plan, employees are offered a specific benefit, which may be based on factors like your years of service at the company.

These days, very few companies offer this type of benefit, instead opting to offer a 401(k) plan or other similar option.

What Are the Benefits of an Employee Savings Plan?

There are a number of advantages to using an employee savings plan. The first is that contributions are tax-free. In most cases, income taxes are paid at the time of withdrawal. That may reduce the amount of taxes you’ll have to pay on your overall salary.

So even though your take-home pay is smaller because of those automatic contributions, your taxable income is also less. Plus you have a growing investment account to help you prepare for retirement or other goals.

Another advantage of participating in an employee savings plan is that your employer could offer a free contribution match as part of their benefits package to retain team members. Research by the Plan Sponsor Council of America found that 54% of employers with this type of plan also offer some type of contribution match.

Employee savings plans also come with larger annual contribution limits compared to individual retirement accounts (IRAs), which are also tax-advantaged. For the tax years 2020 and 2021, the limit for employee savings plans is $19,500 . A traditional IRA, on the other hand, only allows you to contribute $6,000 for the 2020 tax year .

If you’re 50 years or older, both types of plans do allow for an extra catch up contribution. You can add an extra $6,500 for eligible employee savings plans in 2020, but only an extra $1,000 for your IRA .

Employer matches do not count towards your plan’s contribution limit.

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What to Look Out For

While there are a number of advantages that come with an employee savings plan, there are also some pitfalls to beware of.

First, some employers require you to work at the company long enough to become vested before you can access your matched funds.

Being fully vested means that you’ve reached the minimum number of years to be able to make withdrawals from your employer match.

If you leave the company before becoming vested, you do get all of the contributions (and growth) you’ve made in your plan. But if you leave before becoming vested, you may lose the matched funds from your employer.

In some cases, you may receive a percentage of that money based on how long you’ve been there. Either way, it’s important to find out these details from the human resources department at your company, especially if you’re thinking about a job change.

Another downside to an employer savings plan is that although your contributions are tax-free, you do have to pay federal and state income taxes when you make withdrawals.

Another factor to consider is your tax bracket. Some people may expect to be in a higher tax bracket during their prime working years, so the immediate tax deduction may be helpful. Others may end up being in a higher tax bracket after they’ve accumulated wealth over decades and reach retirement age.

In addition to paying income taxes on your withdrawals, employee savings plans also typically come with a 10% early withdrawal penalty if you take out cash before reaching 59 ½ years old. There are some exceptions to this penalty, but be aware of it should you be considering making an early withdrawal.

Also remember that your plan contributions are investments that are subject to risk. It’s not like a savings account through a financial institution that offers a yield based on your deposits. You will typically be responsible for crafting your portfolio and managing your investments. The options available to you may vary based on the specific plan offered by your employer.

No matter how much you contribute, the value of your plan is impacted by the performance of your investment choices, regardless of how much money you contributed over the years. It is also helpful to review your goals regularly and gauge your risk based on your time horizons.

For instance, investors may opt to invest in riskier investment vehicles when they’re younger because the potential for gains may outweigh the risk. As they get older and approach retirement, they may begin to allocate less money to those higher-risk investments.

Finally, be aware of any administrative fees that come with your plan. The average cost is 0.45% of invested assets per year, but fees may vary based on the plan.

Explore different options available within your plan to choose the one that makes sense in terms of both investments and fees.

Borrowing from Your Employee Savings Plan

Many employee savings plans designed to save for retirement allow you to borrow funds from your account if you choose to. The IRS has limitations, such as only being able to borrow the lesser of 50% or $50,000.

You’ll pay interest just as you would with any other loan, but that money gets paid back into your account. This may be one option to consider if you find yourself in need of cash, but there are several drawbacks to be aware of.

The loan terms only apply while you remain at the job providing the employee savings plan. If you leave your job with a loan balance, you must repay the full amount by the due date of your next federal tax return.

Another downside is that if you don’t pay the loan back by its due date, it counts as a distribution and you will likely have to pay income taxes and penalty on the money.

You’ll also miss out on the growth those borrowed funds may have experienced, which could set back your retirement goals.

The Takeaway

An employee savings plan can be an advantageous way to save towards retirement and other goals. It can be especially beneficial if your employer offers matching contributions, which can help boost your savings.

Remember to learn the vesting rules of your company so you know how long you must work there in order to access those funds.

By starting early and automating the process, you can build an investment account with robust contributions throughout your career.

An employee savings plan may be just one part of a well-rounded financial portfolio, but there are other types savings accounts that can be useful.

For shorter goals, like an emergency fund, it may be worth looking into another type of account, like a checking or savings account.

SoFi Checking and Savings is an online bank account that allows users to save and spend in one place.

Looking to save in a convenient account without having to invest? Try SoFi Checking and Savings, which makes saving easy and free of account fees.

Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
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