How Do State-Based Plans Stack Up Against 401(k) Plans?
State-mandated retirement plans increase worker access to workplace savings programs, but they may not be the best fit for employees or employers.
The most important thing you can do to help your employees prepare for retirement is to offer a workplace savings plan. A recent study from the Employee Retirement Benefit Institute (EBRI) shows that workers who have access to a retirement plan at work are far more likely to save for retirement: 79% of those with access to a plan have retirement savings vs. only 17% of those without access to a plan.
Increasing access to a workplace savings plan is an important policy goal in the U.S. Helping more workers save for a financially secure retirement will reduce reliance on government programs for retirees. Policymakers continue to explore new solutions for increasing workers’ access to retirement plans, including incentivizing employers to sponsor a workplace plan, like a 401(k) plan. State governments are also coming up with various strategies to increase workers’ access to workplace savings programs, including requiring employers to participate in a savings plan designed and administered by the state. Since 2012, Georgetown University’s Center for Retirement Initiatives shows that 45 states have taken action to promote access to workplace savings plans, ranging from studying plan options to passing legislation to enrolling employers into a plan.
As of September 2020, a dozen states and one city government have passed legislation to help or require employers to offer a savings plan at work in one of the following ways:
- Voluntary participation in a Payroll Deduction IRA: New York and New Mexico
- Mandated participation in a Payroll Deduction IRA (if not offering another retirement plan): California, Colorado, Connecticut, Illinois, Maryland, New Jersey, Oregon, and Seattle WA
- Voluntary participation in a multiple employer defined contribution plan: Massachusetts and Vermont
- Voluntary use of products from a state-based retirement plan marketplace: Washington and New Mexico
The most popular option: Payroll Deduction IRA Plans
Of the states that have passed legislation to establish a state-based plan, the majority have chosen to require employers to participate in a Payroll Deduction IRA program, also known as an “Auto IRA” plan. Generally, under an Auto IRA plan, employers who do not offer a retirement plan (for example, a 401(k) plan) must automatically enroll their employees into a state IRA savings program. The employer withholds a certain percentage of an employee’s wages and deposits it into a Roth IRA on behalf of the employee. Employees have control over their individual Roth IRA and can opt out of participating. These programs do not allow employers to supplement employee deferrals with matching or other types of employer contributions. The state administers the Roth IRAs and oversees the investment options. The details of each program vary by state. For example,
- The OregonSaves program requires any employer that does not offer a qualified retirement plan to enroll employees at a 5% deferral rate, which must be increased by 1% each year up to a maximum of 10%.
- The Illinois Secure Choice plan requires employers who have been in business for at least two years and have at least 25 employees to automatically enroll employees at a 5% deferral rate.
- The CalSavers plan requires employers with at least 5 employees to automatically enroll employees at a 5% deferral rate with automatic annual increases up to a maximum of 8%.
Pros & Cons of state-based plans
States are increasing access to retirement plans by requiring most employers to offer the state-based plan if they don’t offer another type of retirement plan. The automatic enrollment feature encourages savings among workers who otherwise might not take the initiative to do so. And automatic payroll deduction makes disciplined saving easy and convenient for employees. While employers are being forced into these arrangements, there are little to no costs for the employer and few administrative burdens other than processing the payroll withholding and depositing employees’ money into the IRAs. There are, however, some less-than-ideal aspects of state-based plans that should be considered.
These plans are not subject to the worker protections under ERISA that apply to other tax-qualified retirement savings plans, such as 401(k) plans. ERISA is a federal law that requires fiduciary oversight of retirement plans and provides some uniformity to plan operations nationwide. Each state-based plan has its own rules and features, which can make it more difficult for employees and employers living and working in different states to comply.
Another concern is that workers do not receive a tax benefit for their savings in the year they make contributions because most state-based plans (so far) consist of after-tax contributions to a Roth IRA. Investment earnings within a Roth IRA are tax-deferred until removed from the IRA and may eventually be tax-free. IRAs also have much lower contribution limits than other types of retirement plans. A worker may save up to $6,000 in an IRA in 2020 ($7,000 if they’re age 50 or older), while a worker may save up to $19,500 in a 401(k) plan in 2020 ($26,000 if they’re age 50 or older) and may be eligible for additional employer matching and/or profit sharing contributions.
Pros & Cons of 401(k) Plans
For many employers – even very small businesses – a 401(k) plan may be a more attractive option than a state-based plan for a variety of reasons.
- Flexibility and control over plan service providers, investments, and plan features to meet your company’s needs and objectives
- Tax credit for plan start-up costs for small businesses
- Tax deduction for plan expenses paid by business owner
- Option to make tax-deductible contributions to your employees’ accounts
- Ability as a business owner to save for your own retirement
- Disciplined savings through automatic payroll deduction
- Reduced taxable income through pre-tax salary contributions & greater flexibility with respect to timing of taxes, with option to make Roth contributions
- Tax credits for lower paid employees
- Higher contribution limits than permitted in most state-based savings arrangements (For 2020, employee and employer contributions can reach 100% of an employee’s income up to $57,000 for employees under age 50 and $63,500 for employees age 50 and older, including business owners)
- Access to a broad range of investment options and often additional resources, including managed accounts and/or personalized advice
- Tax-deferred growth on investments while in the 401(k) plan
- Option to take a loan from retirement savings
|Benefits of 401(k) Plan vs Payroll Deduction Roth IRA|
|401(k)||Payroll Deduction Roth IRA|
|Employer contributions allowed||x|
|Plan design flexibility||x|
|Choice of provider||x|
|Small business tax credits||x|
|Tax deductions for employer contributions||x|
|Employee contribution limits (2020)||$19,500 under age 50
$26,000 age 50+
|$6,000 under age 50
$7,000 age 50+
|Combined employee and employer contribution limits (2020)||Up to 100% of employee’s income (max $57,000 for employees under age 50 and $63,500 for employees age 50+ and older, including business owners||No employer contributions|
|Ability for employees to save on pre-tax basis and reduce current tax liability||x|
|Flexibility with respect to employee tax liability||x|
|Additional potential plan features||Personalized advice, employer contributions, loans, hardship distributions|
|ERISA Protection from creditors||x|
Of course, with all these benefits for the employer and employees come some administrative requirements to ensure the tax laws are met. Employers sponsoring a 401(k) plan are also required by ERISA to act solely in the interest of their employees and ensure that they and any others who have discretionary control over the plan or its assets meet the high standards of a fiduciary. Engaging plan providers for document, recordkeeping, and investment support is an added expense for employers.
With the right 401(k) solution, however, employers can offer a robust retirement plan benefit that fits the company’s objectives and employees’ needs, as well as receive expert assistance, while also controlling costs.
Ready for the right 401(k) solution?
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Betterment is not a tax advisor, nor should any information herein be considered tax advice. Please consult a qualified tax professional.