Employer-Sponsored Retirement Plans: Types & Benefits
Once you have the basics covered – food, housing, transportation and a few other things, saving for retirement is likely to become a priority. Many governments have retiree income programs, such as Social Security in the US. However, as is discussed in this post, many of those programs do not replace a large portion of pre-retirement income. In addition, a few people – more in Canada than in the US – are fortunate enough to have defined benefit plans. When it provides a defined benefit plan, your employer promises to pay a fixed benefit after your retirement age until you die. Unless you have a very generous defined benefit payment to support you or you plan to cut back significantly on your expenses when you retire, you will need to save money for retirement. An employer-sponsored retirement plan is one way to save tax-efficiently.
Figuring out how much money you need to retire is a very complicated process. Even though I’ve retired, I’ll never be 100% certain I have enough money. I’ll talk about some of the considerations in evaluating how much you need in a future post. For young people, I suggest saving as much as you can towards retirement. If you find yourself with too much retirement savings, you can always stop making contributions at some point in the future.
Starting Early
Compounding of investment returns, a topic I covered in this post, is a significant benefit of starting early. Here are a few illustrations to show how making contributions when you are younger can help you when you retire.
In the first illustration, assume that you save $2,000 for 10 years and that it earns a 5% return every year.[1] The graph below shows the amount of money you will have saved at each age through age 65 under three scenarios.
The scenarios differ only by the ages at which you make the contributions. The blue line represents how much you will have if you make contributions only from ages 25 through 34. In this scenario, you will have about $114,000 when you reach age 65.
By comparison, the red line corresponds to savings if you make contributions from ages 35 to 44; the green line, ages 45 to 54. Using the same 5% return assumption every year, you would have about $70,000 if you make the contributions for 10 years starting at age 35. You'll have only $43,000 if you start your 10 years of contributions at age 45.
Consistent Contributions
The differences become even larger if you make the $2,000 per year contributions every year until you attain age 65. Using the 5% annual return assumption, you can see how much you will have saved if you start your savings at each of ages 25 (blue), 35 (red) and 45 (green) in the graph below.
In these illustrations, the savings at age 65 are $255,000 when contributions are started at age 25, $141,500 when started at age 35 and $71,000 when started at age 45.
Of course, many people are able to make larger contributions as they get older and (hopefully) make more money. Nonetheless, these illustrations show the potential benefits of starting early with your retirement contributions, even if the amounts are relatively and consistently small.
Types of Employer-Sponsored Plans
Employer-sponsored retirement savings plans, also known as defined contribution plans, can be considered in two broad categories relative to their impact on your income taxes, as follows:
Tax-Deferred Plans
For some plans, the money you contribute to the plan reduces your taxable income. For example, if you make $40,000 and put $2,000 into this type of plan, your taxable wages will be $38,000.[2] You pay income tax on the money in these types of plans only when you withdraw it in your retirement. In the US, the most common form of this type of plan is a Pre-tax 401(k). In Canada, Group Registered Retirement Savings Plans (Group RRSPs), Registered Pension Plans (RPPs) and Defined Contribution Plans (DCPPs) fall into this category.
Plans with Tax-Free Withdrawals
For other plans, you contribute after-tax money. In the example above, you would pay income taxes on your full $40,000 of salary. In exchange, you do not pay income taxes when you withdraw the money in your retirement. The most common forms of this type of plan are Roth 401(k)s in the US and Group Tax-Free Savings Accounts (Group TFSAs) in Canada.
Individual Retirement Plans
Don't worry if you do not have employer-sponsored retirement savings plans. There are IRAs and Roth IRAs in the US and individual RRSPs and TFSAs in Canada that have similar characteristics. See this post for more information about IRAs, as well as the choice between Roth and Traditional retirement plans.
Benefits of Retirement Savings Plans
One of the key benefits of a retirement savings plan is that you almost always pay less taxes if you use one of these plans than if you don't. Another is employer matching. Also, I found that having the money taken from my paycheck before it got to my checking account was very helpful in making sure I saved money for retirement.
Tax Deferral
I’ll use a very simple example to illustrate the tax benefits. Let’s say you are going to save $10,000 of your salary for retirement this year and are trying to decide what type of account to use. Let’s also assume you can earn a 5% taxable return every year on your savings and the applicable tax rate is 20%.
Invest Outside a Retirement Plan
If you invest the $10,000 outside of a retirement savings plan, you will pay 20% of the $10,000 in taxes, leaving you with $8,000 to invest. You will also pay 20% of the 5% earnings in taxes every year. In the first year, you will earn $400 and pay $80 in taxes, so you’ll have $8,320 at the end of the year. After 20 years, you’ll have $17,529 in your account after you make the tax payment for the 20th year.
Invest in a Tax-Deferred Retirement Plan
If you put that money in a Pre-tax 401(k) or an RRSP, you do not pay taxes on the $10,000 when you make the contribution. You also don’t pay taxes on any growth in values until you make withdrawals. At the end of the first year, you have $10,500 in your account. After 20 years, you will have $26,533 in the account. When you withdraw it, you will pay 20% in taxes, leaving you with $21,226 or 21% more than if you had saved the money outside a retirement savings plan.
Invest in a Retirement Plan with Tax-Free Withdrawals
Under these assumptions, you’ll end up with the same amount of money if you deposit your money in a Roth 401(k) or TFSA as if you deposited it in a Pre-tax 401(k) or RRSP. The choice of fund depends on whether you think your tax rate will be higher or lower in retirement. If you think it will be lower, a Pre-tax 401(k) or RRSP will provide more money in retirement. Otherwise, a Roth 401(k) or TFSA will provide more money in retirement.
Employer Matching
Some employers match the contributions you make to their defined contribution plans. As an example, for every dollar you put in your defined contribution plan, your employer might contribute another 50 cents up to a maximum of 3% of your salary. In the US, employer contributions are not taxable to the employee at the time of contribution. Matching contributions are put into a Pre-tax 401(k) regardless of whether the employee’s contributions are put in a Pre-tax 401(k) or Roth 401(k). In Canada, employer contributions to a TFSA are taxable at the time of contribution, but employer contributions to a group RRSP are not taxable to you until you withdraw the money.
Vesting
As an incentive for employees to stay with the company, many employers increase your ownership in these contributions over time. For example, you might own only 20% of the employer contributions if you have been employed by that employer for one year; 40%, if for two years; 60%, if for three years, 80%, if for four years and 100%, if for more than five years. This process is called vesting. Three-year cliff vesting is another common vesting schedule. Under this schedule, you are 0% vested until you’ve worked for the employer for three years and then are immediately 100% vested. If you leave the employer before you are 100% vested, the employer will withdraw the portion of its contributions and any earnings on the employer contributions that have not vested. To be clear, you always own 100% of your contributions.
Employer matching can be a terrific benefit. I always contributed enough to my defined contribution plan to get the maximum match. As long as you stay with the employer until you are even partially vested, the employer contributions are essentially free money. If the employer matches 50 cents on the dollar and you are fully vested, you are earning an immediate 50% return on your contributions. Even if you have the five-year vesting plan above (20%, 40%, 60%, 80%, 100%), you’ll have an instant 10% return on your contributions after you’ve been with the company for one year. That 10% will grow if you continue to work for that employer.
Canada
In Canada, there is a single maximum contribution amount that applies to both your employer-sponsored and individual retirement savings plans combined. If your employer has only a limited number of very conservative investment options, you could save more money for retirement by putting the money in an individual account rather than the employer-sponsored account. For the individual account to have more money upon retirement, you need to be able to invest the money at a sufficiently higher return (i.e., in riskier investments) than can be earned in the employer funds to make up for the loss of the matching funds.
Withdrawals
I won’t spend much time on withdrawals from employer-sponsored retirement savings plans, as I suspect most of my readers are a long way from retirement. Here are very brief explanations.
In the US, you are allowed to start withdrawing from your retirement savings plan without paying a penalty in the year in which you turn 59.5. Also, you are required to take out at least certain minimum amounts starting in the year in which you turn 70.5.
In Canada, you can withdraw money from your retirement savings plan without paying a penalty at any age. Starting at age 71, there are all sorts of complicated rules about converting your RRSP or TFSA to a different type of fund with minimum and maximum withdrawals.
At any age, you can borrow money from some employer-sponsored retirement savings plans for certain purposes, such as a down payment on a house. The details of the amounts you can borrow, for what purposes you can use the money and the borrowing costs vary, so you should talk to your human resources contact if you are considering a loan.
Acknowledgements
Many thanks to Laura Kenney and John McEwen for all of their assistance in providing details about US and Canadian retirement plans, respectively, and for reviewing early drafts of this post.
[1] It is very difficult to earn the same return every single year. I’ll discuss the risks and returns of different investment options in future posts.
[2] I am familiar with only Federal income taxes at a high level. Some states or provinces may require that you pay taxes on these contributions. If you have any questions about your specific situation, you will want to consult a tax specialist.
