The Secure 2.0 Act created a new account type called pension-linked emergency savings accounts or ESAs. ESAs can be made available through employer sponsored retirement plans for plan years beginning after December 31, 2023.

The idea behind pension-linked emergency savings accounts (ESAs) is to create a tax-advantaged account type where the funds are available to participants of any age tax-free. To this end, distributions from ESAs are tax-free, and withdrawals from an emergency savings account are permitted at the discretion of the participant at least once per month.

While a Roth IRA’s withdrawal rules are lenient, the new emergency savings account’s rules are even more so.

Furthermore, participant withdrawals must not be subject to fees or charges from the plan for at least the first four withdrawals of a calendar year. Typically other withdrawals from employer sponsored plans will have transfer fees on them to compensate the administrator or record keeper for the accounting efforts necessary to facilitate the withdrawal. However, no transfer fees on ESAs make it more usable.

While these initial details sound promising, the downsides are many. We can add ESAs to the list of good ideas poorly implemented by Congress.

Problems of Pension-Linked Emergency Savings Accounts

These accounts are “pension-linked.” This means that you only have access to them through your employer’s retirement plan. If an employer does want to have an emergency savings account, they will need to amend their plan document to include it. If your employer decides not to add an ESA to their retirement plan, then you cannot use this account type.

Eligibility is very restricted. Eligible participants for an ESA are only sourced from those who are already eligible to participate in the linked employer plan. Then, eligibility is further restricted to only those employees who are not “highly compensated employees,” a technical term in the retirement plan regulations.

Highly compensated employees are defined elsewhere as those who either own more than 5% of the business or those who receive more than an inflation-indexed total compensation and are in the top 20% of paid employees. In 2023, the compensation amount was $150,000. In well-paying fields, this might mean that 20% of employees cannot contribute to emergency savings accounts due to their high compensation while new employees cannot contribute due to insufficient years of service. Furthermore, most if not all of the owners would also be ineligible to participate.

The regulation does note that if a eligible participant later becomes a highly compensated employee, then they “may not make further contributions to such account but retains the right to withdraw any account balance of such account.” This means that if you can contribute, do so while you can.

Investment options are very restricted. Congress states that the investments of the emergency savings account will be selected by the plan sponsor, but must be held in cash, in an interest-bearing deposit account, or in an investment product designed to preserve principal. This decision is obviously because the intention of the account is for emergency savings. However, this restriction limits your asset location options. Placing those slow-growing, low-yielding assets is better in a taxable account, where annual taxation produces a strong headwind. Meanwhile, Roth environments, like the emergency savings account, are the best locations for high-yield, high-gain investments.

The contribution limit is cumulative not annual. You might have been able to overcome all of these downsides if you could save a lot in the account type. In “How to Budget for Emergencies (The Series),” we recommend that you save at least 10% of your budget each month into an “Unknown Budget” for emergencies. For the highest non-highly compensated employee, this might mean saving $11,000 each year for emergencies.

Alas, the pension-linked emergency savings account features a cumulative contribution limit, not an annual one. This contribution maximum begins at $2,500 in 2024 and then is inflation-adjusted starting after December 31, 2024.

The text of the new tax law is:

(A) IN GENERAL.—Subject to subparagraph (B), no contribution shall be accepted to a pension-linked emergency savings account to the extent such contribution would cause the portion of the account balance attributable to participant contributions to exceed the lesser of—
(i) $2,500; or
(ii) an amount determined by the plan sponsor of the pension-linked emergency savings account.

If you contribute to your ESA over the contribution limit, your contribution can instead be made to the designated Roth account of the plan or returned to you based on plan document rules.

Two Loopholes in Pension-Linked Emergency Savings Accounts

There are two unintended but favorable uses of a pension-linked ESA: 1) employer match churning and 2) employer-supported Roth rollovers.

Employer Match Churning

If an employer provides an employer match on contributions to the plan, then “the employer shall make matching contributions on behalf of a participant on account of the contributions by the participant to the pension-linked emergency savings account at the same rate as any other matching contribution on account of an elective contribution by such participant. The matching contributions shall be made to the participant’s account under the individual account plan that is not the pension-linked emergency savings account.”

This means that if you previously weren’t deferring enough to get your employer match, now you can defer into the emergency savings account, receive the match into your retirement plan, and withdraw the ESA account balance later. This enables you to receive more employer match than the assets that ultimately remain in the plan suggest you deserve.

Because this use of the account is so obvious, Congress added an anti-abuse section where they state:

(f) ANTI-ABUSE RULES.—
(1) IN GENERAL.—A plan of which a pension-linked emergency savings account is part—
(A) may employ reasonable procedures to limit the frequency or amount of matching contributions with respect to contributions to such account, solely to the extent necessary to prevent manipulation of the rules of the plan to cause matching contributions to exceed the intended amounts or frequency; and
(B) shall not be required to suspend matching contributions following any participant withdrawal of contributions, including elective deferrals and employee contributions, whether or not matched and whether or not made pursuant to an automatic contribution arrangement described in section 402A(e)(4) of the Internal Revenue Code of 1986.

This implies that your plan document may have rules in place to prevent employer match churning through the pension-linked emergency savings account. However, I imagine it will be difficult to create rules that completely prevent the strategy.

Employer-Supported Roth Rollovers

The new tax code needs a provision for what happens if an employee is terminated from employment or if the pension-linked ESA is closed. That relevant section reads:

(e) ACCOUNT BALANCE AFTER TERMINATION.—Upon termination of employment of the participant, or termination by the plan sponsor of the pension-linked emergency savings account, the pension-linked emergency savings account of such participant in an individual account plan shall—
(1) allow, at the election of the participant, for transfer by the participant of the account balance of such account, in whole or in part, into another designated Roth account of the participant under the individual account plan; and
(2) for any amounts in such account not transferred under paragraph (1), make such amounts available within a reasonable time to the participant.

This means that the participant can elect to rollover the balance of their pension-linked emergency savings account to another designated Roth account or Roth IRA if the ESA is ever terminated by the plan sponsor.

Thus, the second loophole is that a plan sponsor can create a pension-linked emergency savings account on their plan document and allow employees to contribute to it. Then, the employer can terminate the ESA and allow employees to rollover the balance to their Roth IRA. Later in a new plan year, the sponsor could reestablish the plan and repeat the process again.

This process would cost the plan sponsor refiling fees each plan restatement. It also wouldn’t benefit any of the owners or highly compensated employees. However, it is another loophole available in these rules.

Why don’t they let participants rollover funds to a Roth IRA without termination? Why create a new account type instead of just relaxing the Roth IRA withdrawal or contribution rules? Why tie the account to employers or earnings at all? The questions go on and on, as they do with many other parts of the tax code. Why do homeowners with loans get a deduction when renters don’t? Why are business profits taxed twice, once as profit and once as the dividend or capital gain? Why does the tax code penalize those who create wealth? Why do some industries get special treatment?

Congress can do better, but right now there is no logic to the tax code. As with other provisions, take advantage of this one if you can. If you can’t, do not worry; the benefit available from it is small anyway.

Photo by Clay Banks on Unsplash. This image has been rotated.