The pros and cons of in-plan and out-of-plan ESAs under SECURE 2.0

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Devin Miller
April 12, 2023

In the early 2000s when healthcare costs were skyrocketing, and after high-deductible health plans began to become more popular, Congress passed legislation that formalized a new type of employer benefit: health savings accounts, or HSAs. When the Medicare Modernization Act passed in 2003, it created these plans, which allow employees to place pre-tax dollars into a specific savings account that can be used for certain medical expenses.

According to Becker’s Hospital Review, by the end of 2021, there were 32 million HSA accounts with more than $100 billion collectively saved. These accounts have helped alleviate employee stress that’s generated by both planned and unplanned medical expenses — but they are limited in scope and application.

Twenty years later, emergency savings accounts, or ESAs, are experiencing a similar growth trajectory. Recent legislation (the SECURE Act 2.0) created a framework for how employers can generate and deploy in-plan ESAs, a new option for companies that want to provide their workers with more financial security.

What is an in-plan ESA? How is it different from an out-of-plan ESA? What are the benefits and drawbacks to each type? Let’s walk through how employers can best decide which form of ESA will work most effectively for their business.

The SECURE Act 2.0: Some background

In December 2022, the SECURE 2.0 Act was finalized. This bill focused on employer retirement savings options, with the stated intention of expanding coverage and increasing savings for Americans.

One of the sections in the act changed how employees can withdraw funds for certain emergency expenses. Before the act, employees who needed to pull money out of their retirement accounts — such as a 401(k) account — for emergencies would almost always have to pay a 10% penalty for the early withdrawal.

According to the CFPB, almost one-quarter (24%) of consumers have no emergency savings; 39% have some emergency savings, but it’s less than one full month of income; and 37% have at least one month of income saved for emergencies. And 59% of consumers surveyed who had no emergency savings had also withdrawn money from a retirement account in the past year. In 2022, a record number of people with 401(k) plans made a hardship withdrawal.

The SECURE 2.0 Act allows an exception to this penalty: Effective after December 31, 2023, employees can pull up to $1,000 per year from their retirement accounts for emergency expenses, but they must pay back the withdrawal before they can borrow more money from their retirement funds.

Another section in the act created the option for employers to implement in-plan (or pension-linked) ESAs. What exactly are these? 

What is an in-plan ESA?

An in-plan ESA is an emergency savings account that is administered within a defined contribution retirement savings plan, like 401(k) or 403(b) retirement plans. Sometimes called a “sidecar” emergency savings account, an in-plan ESA is connected to a retirement plan, allowing for direct payroll contributions from the employee.

The in-plan ESA is a separate account from the defined contribution plan, but they are linked: When the employee contribution cap for emergency savings is reached, any additional contributions get rolled over into the defined contribution plan. 

The money in these ESA plans must be “principal-protected,” meaning that these accounts can’t depreciate in value following economic trends, like a retirement fund might. And the money also has to be easily accessible to the account holders in case of emergency.

The benefits of an in-plan ESA

Apart from the obvious high-level benefit of providing employees with emergency savings options (and more peace of mind), there are a handful of reasons why employers might choose an in-plan ESA.

If a large proportion of employees are already enrolled in and contributing to a defined contribution retirement savings plan, then adding an in-plan ESA might be more convenient for those employees. And because the in-plan ESA is linked administratively and otherwise to the retirement plan, and employers can automatically enroll employees, it might be more affordable for some companies to launch.

The drawbacks of an in-plan ESA

Although any emergency savings plan is better than none, there are also some significant cons to an in-plan ESA that don’t exist with out-of-plan ESAs (more on those in a bit).

Highly compensated employees are exempt from some of the credits and from enrolling in pension-linked emergency savings accounts. It’s up to employers to track and monitor compliance with these rules, which might limit reach for the programs.

An in-plan ESA has a cap on employee contributions. Employees can contribute up to $2,500 to an in-plan ESA, and employers have the option to lower the cap if they choose. Any amount contributed above the cap will spill over into the employee’s retirement account, but if an employee wants to save more than the cap toward a potential future emergency, they can’t do it in the in-plan ESA.

What happens if an employee leaves the company for greener pastures? There is no easy “portability” of an in-plan ESA account. If they leave the company, they have to either withdraw the in-plan ESA funds as cash, or roll those funds into their defined contribution plan and then transfer their retirement savings to their new employer. If their new employer doesn’t have an in-plan ESA, it’s not clear if the money will have to be withdrawn. Pending guidance from the IRS may address this.

In-plan ESAs must adhere to the guidelines set up by the Employment Retirement Income Security Act of 1974 (ERISA), which might negate the administrative streamlining of packaging an ESA plan with a retirement plan — it could mean more work and a heavier lift for HR and finance departments.

And finally, for an employee who’s experiencing an emergency, understanding how to withdraw emergency funds (and making sure they’re taking those funds out of the in-plan ESA instead of their retirement savings) might be confusing, depending on the plan.

What is an out-of-plan ESA?

An out-of-plan ESA is also an emergency savings plan, and it’s also sponsored by employers. The difference is that it’s not tied to a retirement savings account, which can provide more flexibility and solutions for both employers and their staff members.

The benefits of an out-of-plan ESA

Employers have more choices and flexibility around how to structure the out-of-plan ESA, and whether and how to match any employee contributions to an out-of-plan ESA. They can offer out-of-plan ESAs to employees who would not otherwise qualify for a retirement savings plan (such as part-time or seasonal workers), and they can also differentiate between different types of ESAs for different workers: one for hourly employees and one for salaried employees, for example.

Another huge benefit is that there is no cap on the amount of contribution that an employee can make to their emergency savings. They can save more than $2,500 if they feel they might need it someday, and emergencies that stretch beyond that $2,500 cap can still be fully covered with the out-of-plan ESA if the money is in the account. Most financial advisors recommend saving enough money to cover three to six months’ worth of expenses, although saving for eight months’ to a year’s worth of expenses can provide a better cushion against debt — whatever the goal, an out-of-plan ESA can accommodate as much savings as the employee needs.

One of the biggest benefits of an out-of-plan ESA is that the money is more easily accessible in an emergency. These versions of an ESA do not have to conform with ERISA and are entirely separate from retirement savings, so if an employee needs to access their funds quickly, an out-of-plan ESA is generally more efficient at releasing the money.

In some ways, an out-of-plan ESA can be easier for HR and finance departments to manage. They are not subject to ERISA regulations, and there is a great deal of variability in how they can build and implement these plans as a result.

If employees do leave, there is also more portability available around an out-of-plan ESA beyond closing the account to cash-out or rolling it into the retirement savings.

The drawbacks of an out-of-plan ESA

With all the adaptability built into out-of-plan ESAs, are there any inherent cons or drawbacks? The separation of an out-of-plan ESA from a retirement savings plan could make it costlier to initiate for companies that already have defined contribution plans. And there is no auto-enrollment available for out-of-plan ESAs, however there is draft legislation in the works to add it to these plans.

So which is better for my business: An in-plan ESA or out-of-plan ESA?

An ESA or emergency savings plan can give employees a financial edge by providing them with a way to cover a financial emergency without dipping into their retirement savings plan. It’s an important benefit for employers to offer employees, and whether an in-plan or an out-of-plan ESA will be better will depend on a number of variables. These aren’t necessarily one-size-fits-all solutions!

That said, many employers find that the additional flexibility and options available with out-of-plan ESAs, such as those provided by SecureSave, can increase plan participation, generate employee satisfaction, and create a safety net for staff members who might not be able to knit one on their own. 

The best way to decide what will work most effectively for you is to talk to your current benefits provider as well as an out-of-plan ESA platform, then compare and contrast what they’re offering. We’ll certainly be happy to help with any questions!

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