Don't be surprised when employers either ax or scale back contributions to 401(k) retirement plans during a financial downturn. American Express, Coca Cola Bottling Co. and General Motors are among the dozens of companies that suspended their matching payments to their employee's plans during the recession of 2008/2009, according to the PensionRightsCenter.
Many businesses attempt the quick and easy move to save cash and sometimes avoid layoffs. Although the action is typically temporary, it can derail retirement goals for some employees. It can also create tough decisions for those individuals nearing retirement, such as whether to increase their contributions, reduce goals or delay retirement. The blow of the setback, however, can be lessened. Read on to find out how to maneuver around changes to an employer's 401(k) contributions.(Learn more on the plan in our Roth 401(k) Tutorial.)
Effects of Changes to Employer's Contributions
The IRS considers a 401(k) plan a type of tax-qualified deferred compensation plan. An employee chooses to have the employer contribute a certain amount of cash wages to the plan on a pretax basis. The deferred wages aren't reflected on the Form 1040 or the W-2, but are included as wages subject to Social Security, Medicare and federal unemployment taxes.
Employers are not required to match contributions workers make to their 401(k) plans. The match is simply a means to get employees motivated to save for retirement.
The average employer match is about 50 cents on the dollar for the first 6% of pay according to a 2009 study by Hewitt, an HR consulting and outsourcing company. If an employer decides to suspend its 401(k) match based on this average, it could save $1,500 per employee each a year. A large company could pocket $25 million annually, an average-sized company could save $10 million and small company could keep $2 million. (For more tutorials that are each devoted to one the most common retirement plans, explaining how to establish, fund, and then take distributions from it, see Introductory Tour through Retirement Plans.)
A huge gap exists between the amount of money U.S. employees have saved and what they need to shore up in order maintain their standard of living during retirement. Some reasons AARP offers for why Americans aren't saving are that they may find the investment information confusing, aren't knowledgeable about finance and become too embarrassed to ask questions. Even if employees do contribute, it's often too little and too late.
For example, during the height of the recession of 2008-2009, Hewitt Associates annual Universe Benchmarks study discovered investment allocations in equity funds were at record lows. "The average 401(k) balance dropped from $79,600 in 2007 to $57,200 at the end of 2008. Forty-four percent lost a 30% or more of their savings. Only 11% of employees were able to break even or see a gain in their 401(k) portfolios," the study found.
The suspension of an employer's match often lowers employee morale and dissuades their participation in the retirement plan. Some people reduce their own contributions or just stop altogether. For example: if a younger worker earned $50,000 a year, contributes 6% of his or her salary and the employer stops the employee's contribution for a year, that worker will have $16,000 less saved for retirement 25 years later. If that same employee stops making his own contributions, he would have $32,000 less.
3 Things to Consider When an Employer's 401(k) Contribution Changes
Here's what you can do to recover from your employer's contribution changes:
- Step up your contributions.
If your employer stops making contributions, continue to make contributions on your own. Fill in the gap your employer left behind by adding more and double up if you can. Hewitt Associates advises that if an individual increases contributions by three percentage points per year, he or she can negate the effects of the cancellation. If the employee can't save that much, he or she should find out whether the employer has automatic escalation. This allows workers to up their contributions in smaller increments, such as 1-2% year.
The impact of not making contributions as a young adult is greater than someone who is nearing retirement. The person nearing retirement has built up a nest egg and doesn't have as many years for compounding. However, a person age 55 who stops making contributions will still significantly reduce his or her potential retirement account. This is because these are also your highest earning years.
- Consider a Roth IRA.
Roth IRAs allow an individual with qualifying income to contribute money that's already been taxed, so when retirement is reached the withdrawals are tax-free. In other words, the tax breaks for the 401(k) plan don't occur with the Roth IRA. If you owned the IRA account for no less than five years and are at least 59.5 years old when you take the money out, you won't have to worry about taxes.
Another perk is the ability to transfer contributions from your bank or paycheck. Since the Roth IRA has an income ceiling, it may be a more advantageous move for a younger worker with a lower paycheck and less tax rates than an older worker at a higher paying job. AARP has a calculator that examines differences between the investments made to a 401(k) plan and a Roth IRA and its impact on a paycheck. (Learn more in The Simple Tax Math Of Roth Conversions.)
- Avoid dipping into your retirement fund.
Cashing out your retirement fund comes with several tax consequences, so be prepared. Nearly half of employees do this when they leave their job, Hewitt Associates found, which will cause a worker to give up 20% or more of the account's value. Making a withdrawal is treated as taxable income, which may require payment of federal taxes and an early withdrawal penalty.
The National Association of Personal Financial Advisors better demonstrates this through an example of a 45-year old holding $100,000 in a 401(k) account and assumed to be in the 35% federal tax bracket. The individual would owe $35,000 in federal taxes on a cash withdrawal, including possible state and local taxes. A 10% early withdrawal is likely because the individual is under the age of 59.5. Basically, the fees could cut the account nearly in two, the NAPFA explained. Regardless of age, dipping into your retirement funds early will mean less principal and this will equal less money to accumulate investment returns on.
The Bottom Line
Employers usually limit or stop making their matching contributions during hard times, but quite often the change doesn't last. Maneuvering around this change includes making up for the loss, considering a Roth IRA and digging into the funds. You can also try rebalancing asset allocation and getting advice from financial professionals. (You've accumulated the wealth you need to retire, but how will you distribute it? We'll lay out some options in Systematic Withdrawal Of Retirement Income.)