Employee Savings Plan (ESP) Definition, Types, Tax Benefits

What Is an Employee Savings Plan (ESP)?

An employee savings plan (ESP) is a plan provided by an employer that allows employees to set aside a portion of their pre-tax wages for retirement savings or other long-term goals, such as paying for college tuition or purchasing a home.

Many employers match their employees' contributions up to a certain dollar amount, or a certain percentage. A popular ESP in the U.S. is the 401(k) retirement plan, which offers four types of plans.

Key Takeaways

  • Employee Savings Plans (ESPs) are employer-sponsored savings and investment plans that allow employees to make contributions using pre-tax dollars.
  • 401(k) retirement plans allow employees to contribute up to $20,500 towards retirement for tax year 2022 and up to $22,500 for tax year 2023, potentially with additional contributions made by employers.
  • Additional 401(k) catch-up contributions for employees 50 and older can be up to $6,500 for 2022 and $7,500 for 2023.
  • Contributions to 401(k) plans are tax deductible; withdrawals are added to taxable income.
  • Health savings accounts (HSAs) are another type of ESP intended for health expenses.

Understanding Employee Savings Plans (ESPs)

Employees are always fully vested in their own employee savings plan contributions. However, many plans require that employees remain employed for a minimum amount of time before they are vested and eligible to withdraw employer-matched funds.

ESPs can be an attractive and relatively easy way for employees to lower their taxes and save for long-term goals. In fact, with the phasing out of corporate defined-benefit pension plans, ESPs are becoming the sole option for individuals to save for retirement through their employer.

Defined-Contribution Plans

ESPs mostly support saving for retirement and come in two main forms: defined-contribution plans offered by corporations (known as 401(k) plans), and those offered by public or non-profit entities (known as 403(b) or 457(b) plans). Contributions to both types of plans are made through payroll deductions that lower employees’ taxable income.

Many employers offer Roth versions of these plans. The employee's contributions to Roth accounts are made with after-tax dollars, so they don't reduce gross income. However, qualified withdrawals are tax free if certain conditions are met.

The money contributed to traditional 401(k) plans grows tax-deferred until funds are withdrawn in retirement and such distributions are included in taxable income.

For 2022, the contribution limit for employees who participate in 401(k), 403(b), most 457 plans, and the federal government's Thrift Savings Plan is $20,500. For 2023, that limit is $22,500. Those age 50 and over can add an additional catch-up contribution of $6,500 for 2022 and $7,500 for 2023. Employer matching contributions do not count against this total.

Employers can match an employee's contributions to a Roth 401(k) or Roth 403(b) plan. However, these contributions go into the traditional version of the plans, meaning they are subject to taxes when the funds are withdrawn.

Other Key Components

Defined-contribution plans also offer portability, meaning an employee who switches jobs can either roll over their plan balance into an identical plan at their new employer or transfer the balance into an individual retirement account (IRA) that they maintain on their own.

Assets in a personal IRA also grow tax deferred until withdrawn. IRAs have lower annual contribution limits than 401(k) plans. For 2022, individuals can contribute up to $6,000 to an IRA, or $7,000 if age 50 or over. For 2023, the limit is $6,500, or $7,500 if age 50 or over.

Health Savings Account

A Health Savings Account (HSA) is another example of an ESP. These tax-advantaged accounts allow individuals with high-deductible health plans (HDHPs) to save for medical expenses that HDHPs do not cover. Contributions are made into the account by the individual or the individual's employer and are limited to a maximum amount each year. The contributions are invested over time and can be used to pay for qualified medical expenses, which include most medical care such as dental, vision, and over-the-counter drugs.

Less Common Employee Savings Plans

In addition to or in place of defined-contribution plans, some employers offer profit-sharing plans in which the employer makes an annual or quarterly lump sum contribution into a tax-deferred account that could be a 401(k).

Non-qualified deferred compensation plans, though less common, are another way for highly compensated employees to save for retirement or other financial goals. These plans allow participants the opportunity to make pre-tax contributions up to 100% of their annual compensation but are typically reserved for a limited number of high-earning employees within a company.

They offer greater flexibility than defined-contribution plans in terms of withdrawals for college or other non-retirement goals but do not carry the same protections as qualified plans.

What Is an ESP?

The Employee Savings Plan, or ESP, is a savings plan offered by employers that allows employees to save over many years via paycheck deductions for a variety of goals, such as retirement. Some employers may add to their employees' savings with matching contributions.

What Kinds of Tax Benefits Do ESPs Offer?

Normally, contributions to defined-contribution plans (such as a 401(k), one type of ESP), are tax deductible for employees. What's more, all the money in these accounts grows tax-deferred over what can be, ideally, many years.

Do I Pay Taxes on Money I Take Out of an ESP?

Unless your ESP is a Roth, yes, you'll pay taxes on withdrawals after you retire. That's because you get a tax break upfront with contributions that are deductible from your taxable income. If you participate in a Roth ESP, you don't get that upfront tax deduction but you won't owe any taxes when you make qualified withdrawals.

The Bottom Line

Employee Savings Plans are employer-sponsored retirement savings plans that offer tax-advantaged opportunities to invest for the future. They include various defined-contribution plans such as the 401(k), 403(b), and 457(b), where contributions made by employees are tax deductible and the money in the accounts grows tax-deferred for years, until withdrawn.

The Roth version of the 401(k) and 403(b) involves after-tax contributions (which are not tax deductible) but qualified withdrawals are tax free.

Health Savings Plans, profit-sharing plans, and non-qualified deferred compensation plans are other examples of ESPs.

Article Sources
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  11. Internal Revenue Service. "IRC 457(b) Deferred Compensation Plans."

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