Coronavirus has had a dramatic effect on the world’s economy, from causing chaos in the investment markets to limiting the profitability of previously viable companies. Many organizations are using furloughs or forced personal time, as well as salary cuts, to keep afloat. Another strategy that many companies have undertaken is stopping matching contributions to employee 401(k) plans.
While this sounds like a drastic step, it can help companies avoid laying people off, although it also can derail savings goals for employees. People close to retirement become the most affected as they often need to decide whether to reduce savings goals, increase their own contributions, or simply delay retirement. However, virtually all employees get impacted by this decision.
If you’re faced with this situation, this is what you need to know.
Important Background on 401(k) Plans and Employer Matches
Through a 401(k) plan, individuals can have a portion of wages taken out of their paychecks prior to taxes being assessed and placed in the savings account. Because the contributions do not count toward income tax in the year in which they are made, having a 401(k) plan actually reduces a person’s taxable income.
When employers match contributions to a 401(k) plan, they generally frame it through a percentage of the employee’s salary, although workers can contribute more than their companies agree to match. Sometimes, employees think that the point of a 401(k) plan is getting this employer match, especially since it was extremely common about a decade ago. However, companies are not required to match contributions and generally only do so retain employees.
Employer matches are expensive for businesses to maintain. During the first quarter of 2019, the average match was about 4.7 percent of an employee’s salary, which is an average of $1,780. A company that has 1,000 employees with this sort of matching program would end up saving $1.78 million annually by stopping the program.
Unfortunately, suspending this program can lower morale and discourage employees from making their own contributions. The long-term financial impact is also quite dramatic. A person who makes $50,000 annually at a company with a 5-percent match would likely lose out on more than $13,000 over the course of 25 years if the employer suspends the program for only a year assuming a modest rate of annual return.
Potential Approaches for Making up the Difference in Savings
When employees hears that a company is eliminating its 401(k) match program, they may be upset, but it is important not to make any emotionally-driven decisions. Individuals can take some important steps to recover and keep themselves on track for retirement.
The most critical move to make is increasing personal contributions. Increasing contributions reduces taxable income. This means that individuals may actually be able to get themselves into a lower tax bracket if they contribute more.
It is important to recognize that not everyone can increase contributions immediately. Instead, people may need to increase their contributions when they get a raise. They may also opt for automatic escalation, which means small increases in personal contributions each year.
Another option that individuals may want to consider is opening a Roth IRA account. People can make contributions to both a 401(k) and a Roth IRA at the same time depending on income level. Contributions to a Roth IRA are not tax-deductible, but people can make tax-free withdrawals during retirement. This tool is especially important for individuals who think they could actually end up in a higher tax bracket while retired.
Younger people who are just starting their careers and are therefore in lower tax brackets can benefit from a Roth IRA. This is because they will likely pay lower taxes on the money now than once they retire. Also, having both types of accounts in retirement offers greater flexibility. Retirees can adjust withdrawal strategies according to market performance.
The Actions to Avoid When Dealing with a Suspended Match
In general, withdrawing funds from a 401(k) prior to reaching retirement age is not a good idea. People will face a 10-percent early withdrawal penalty with very few exceptions. They will also need to pay income taxes on the money beyond that fee. Furthermore, individuals miss out on all the compounded interest that would result from that money until it is replaced.
When individuals stop getting an employer match for their 401(k), they need to become more diligent about protecting the money in the account. Since the total saved will now be lower unless individuals can significantly boost their personal contributions, it is important not to cause additional setbacks by making withdrawals from the account.
The other thing that people need to avoid is using the matching suspension to justify decreasing their own contributions. Right now, the market is unstable and many people are hesitant to part with more money than they feel is necessary. However, reducing personal contributions will only exacerbate savings issues down the line. If it is not possible to increase savings, contributions should remain stable.