Different Retirement Plans Explained: How to Break Down 401Ks, Roths, and More for Your Employees
If you’re not a financial expert or HR professional, the various retirement plans and details that go along with them are enough to make your eyes glaze over. (All those acronyms don’t help!) What’s worse, 4 in 10 employees say they’re saving less in their retirement plans as a result of the pandemic. Your employees are confused about their benefits, and they’re making costly decisions that could hurt them in the long run. To empower your team to take control of their long-term financial planning, the first step is to ensure they understand the primary retirement plan definitions.
For those who’ve tried to explain the difference between retirement accounts, the value of compounding interest, or contribution/matching limits, and felt like the teachers on Charlie Brown (“wah wah wah”)—this article is for you. Below, you’ll find the different retirement plans explained, along with pros and cons for each, as well as a comparison chart—all sans jargon. Use this as a handy guide to help your employees understand retirement options and start taking advantage of the right retirement plans in 2021.
What is a 401(k)? There are two main types of employer-sponsored 401(k) retirement plans: traditional and Roth. While these two accounts function in many of the same ways, the difference comes down to taxes. If you offer both types, your employees might not understand the difference. One of the best ways to explain is to use real examples, and outline the pros and cons of each. Here’s how:
A traditional 401(k) is the most popular employer-sponsored retirement plan. This one’s for anyone who wants to put off paying taxes.
With a traditional 401(k), any money you save or invest won’t be taxed until you withdraw it in retirement. At that time, your 401(k) is considered income and will be taxed at your current tax rate (both federal and state). Another benefit to a traditional 401(k) is that you reduce your overall annual income, so you’ll pay lower taxes while you’re still working.
Example: If your annual salary is $55,000 and you contribute $5,000 to a traditional 401(k), you’ll only pay taxes on $50,000 for that year.
- Employer-managed: It’s an easy way to save for retirement. Money is taken out of each check, and saved/invested by your company’s retirement plan vendor.
- Contribute more each year: These accounts have one of the highest contribution limits for retirement plans, at $19,500 (increasing to $26,000 after the age of 50).
- Increased saving potential: Because contributions aren’t taxed, employees can theoretically save more, which can then accrue more interest, earning more money in the long run.
- Protected money: 401(k)s are protected by the ERISA law, which means you’ll never lose the money you’ve saved (even if you change employers).
- Taxes at withdrawal: When you take out money at retirement, you’ll pay taxes at the current federal and state rates. That could be a hefty sum if tax rates rise throughout your career, and if you’ve saved a sizable amount for retirement.
- Less oversight: With a 401(k), individuals can’t control their investments as much as with self-managed retirement plans.
A Roth 401(k) functions very similarly to a traditional, with one large difference—contributions are made with after-tax dollars.
This one’s for anyone who wants to pay taxes now. When you pull out money during retirement, you won’t pay any taxes on it.
- Employer-managed: Like a traditional 401(k), a retirement plan vendor controls and manages these accounts for you.
- Similar contribution levels: Roth 401(k)s have the same annual contribution limit as a traditional 401(k), at $19,500 (or $26,000 for age 50+).
- Secure account: These types of 401(k)s are also protected and transferable upon leaving a company.
- No taxes upon withdrawals: When you retire, the money you see in your Roth 401(k) is what you’ll be able to take out—no tax deductions needed.
- Limited availability: Not all companies offer this type of 401(k) as an option.
- Not as much control: Just like its traditional counterpart, if you want to manage your own retirement account and have a broader range of investment options, this won’t allow for it.
While it seems like employer matching should be an easy enough concept to understand, as many as 20% of Americans don’t take advantage of this benefit. So how does employee 401(k) matching work? That’s why the best way to explain it is to call it free money.
This is another area that’s perfect to use a hypothetical scenario to reinforce your point, along with pros and cons:
Example: “Our company matches your 401(k) contributions dollar for dollar, up to 6% of your salary. Let’s say you make $55,000 and contribute the full 6%. In just one year, you’ll put $3,300 in your 401(k), and we’ll add an additional $3,300. That’s absolutely free money that you receive as a benefit from our company for investing in your future retirement!”
- Level up your contributions: You can significantly increase the amount you save for retirement each year.
- Increased earning potential: The more money saved each year, the more interest earned.
- Easy process: Employer matching happens automatically. Employees don’t have to do anything!
- Literally none. 🙂
Even if you offer an employer-sponsored retirement plan, your employees might still want to look into individual retirement accounts (IRAs). Part of empowering your staff to be financially literate for long-term planning includes educating them on all the available options.
An IRA can be a good choice if an employee wants to diversify their retirement portfolio, they’ve maxed out 401(k) contributions, or you don’t offer a company-sponsored plan. Here too, you’ll want to make sure to describe the differences between traditional and Roth IRAs.
Much like a traditional 401(k), a traditional IRA allows you to contribute pre-tax dollars to a retirement account. For those without company-sponsored retirement plans, it’s also important to note to your team that they can deduct traditional IRA contributions from their taxable income.
- More control: The employee is in the driver’s seat regarding investment choices and risk tolerance.
- No Income limits: Unlike its counterpart (Roth IRA), there isn’t an income cap to open/contribute to a traditional IRA.
- Tax-deductible: If the account holder (or their spouse) doesn’t have another 401(k) or retirement plan, they can deduct their contributions from their annual taxable income.
- More complex process: When it comes to IRAs, there are tons of financial institutions and endless details to choose from. This could be a more overwhelming process for those who are unfamiliar.
- Lower contribution limits: In 2021, individuals can only contribute $6,000 (or $7,000 for age 50+) to a traditional IRA.
- Taxed at withdrawal: When a traditional IRA is cashed out at retirement, the account holder pays income taxes on the full amount at their current tax rate.
While these two accounts function similarly, the main point to drive home with a Roth IRA is that you contribute post-tax income, and it’s also income-dependent.
- Self-managed: Like a traditional IRA, the individual is in charge of investments and running their own money.
- No tax at withdrawal: Because contributions are post-tax, what you see is what you get with your Roth IRA. Account holders pay no additional taxes at retirement time.
- Eligibility rules: There are income limits for both opening and contributing to a Roth IRA. If a person makes a certain level of money, they might not be able to even open this account or contribute to it. (These vary, refer to this resource to see different limits).
- Lower contribution: This has the same contribution ceiling of $6,000 (or $7,000 for age 50+).
Last acronym, we promise!
While a health savings account (HSA) is primarily a tool your employees can use to save for current medical expenses, it’s also a great way to save for the future. And only 7% of HSA holders say they’re currently investing, so this could be a big area of opportunity for your employees.
In order to drive home the power of an HSA, tell your employees about the “triple tax advantage,” meaning:
- All contributions are tax free.
- Any interest earned is tax-free.
- Any money you withdraw is tax free (whether it’s for medical expenses now, or retirement later.)
- Rollover: The funds in an HSA account never expire and roll over year-to-year, unlike an FSA.
- Earning potential: When not being used, this money can be invested to increase earning ability.
- Pairs well with HDHPs: This account can be used for medical expenses for those with substantial out-of-pocket health care costs.
- Save for retirement: Upon retirement, individuals aren’t restricted to spending HSA money on medical-related expenses.
- The triple-tax advantage: Contributions, interest earned, and withdrawals are all tax-free.
- Qualifying factors: Not everyone can start an HSA; an individual must have a qualifying HDHP, not be on Medicare, and not be a dependent on anyone else’s tax return.
- Restricted use: Until retirement, account users can only use this money for medical or health-related expenses.
- Lower contribution limits: As this is designed to cover medical expenses, the contribution limits are lower than other typical retirement options—$3,600 for individuals ($4600 for age 55+) and $7,200 for families.
Retirement Plan Comparison Chart
Supporting your employees means helping them prepare for their future in a way that makes sense to them. The messaging you create and conversations you have will shape their decision-making.
The first step is education about basic retirement plan definitions, advantages and disadvantages of each, and available resources. Use this chart for a quick reminder of the fundamental differences between retirement plans:
Type of plan
Employer or self-managed
Can be both
When you have the task of ensuring different retirement plans are explained, it can feel daunting. To make your job easier, use the above strategies, examples, pros and cons, and chart to describe these plans in plain English so that every team member gets the full picture.
When your team feels confident in their decision-making, you can even make a case for diversifying and opening/contributing to multiple accounts to maximize tax benefits and earning potential.Take it a step further and use a benefits guidance tool like ALEX to ensure your employees understand and utilize their retirement options.