Definition and Example of 401(k) Match
A 401(k) contribution often represents a percentage of an employee's salary, and employers who offer matching contributions do so up to a certain percentage. How employers structure their plans can vary. Some may allow employees to choose a flat dollar amount rather than a percentage of earnings, and some matching contributions may be defined as a percentage of the employee's contribution. For example, an employer might match 50% of what an employee contributes with either a maximum dollar amount or no cap. Some generous employers might even match 100% with no cap.
For example, an employer might agree to match contributions up to 5% of an employee's salary. In that case, if an employee earning $1,000 per week were to contribute 5% of her salary, and her employer were to match that amount, she'd see her 401(k)'s principal balance grow by $100 per week even though she was having only $50 deducted from her weekly paycheck.
With the benefits of compound returns, your 401(k) match, along with returns, can make a big impact within a few short years. The $50 per week that your employer chips in adds up to $2,600 per year and $26,000 within 10 years—and that's before investment returns. A return of 5% on $26,000 would mean another $25 per week in your account.
How a 401(k) Match Works
When signing up for your employer's 401(k) plan, you'll establish how much money you wish to contribute from each paycheck, and that amount will be deducted before income and payroll taxes are calculated. Your employer's matching contribution will be calculated automatically, depending on its policy.
Your employer might agree to match 100% of your 401(k) contributions up to 5% of your paycheck. So, if your paycheck were $1,000, the employer would match your contribution dollar for dollar, up to $50.
Many 401(k) plans require you to work a certain length of time before you are eligible to receive all the money your employer has contributed. Once you have stayed with the company for that length of time, you are said to be "fully vested" in the plan and can take all the employer-matched contributions once you retire or leave for a new job.
Employers use graded vesting as an incentive to encourage company loyalty. If you are only 50% vested when you leave your job, that means you could leave with only 50% of the money from your employer's match.
Many employers establish a graded vesting plan that gives you increased access to the matched funds the longer you work for the company, up until the fully-vested date. For example, an employee might not able to participate in the 401(k) until she has been with the company for one year. Her company might allow her to have access to only 25% of the matched contributions at the end of her second year. Her vesting would increase by 25 percentage points each year until she becomes fully vested after five years as an employee.
Is a 401(k) Match Worth It?
Aside from money that is basically given to you by your employer for your retirement, another good reason to take advantage of a 401(k) match is that it allows you to exceed the annual 401(k) maximum contribution limits set by the IRS. For 2022, you can contribute up to $20,500 of pretax income to a 401(k). If you are 50 or older, you can contribute another $6,500 in what are called "catch-up contributions."
When including employer contributions, the maximum amount you can contribute in 2022 is the lesser of $57,000 for participants 49 or younger ($63,500 for participants 50 or older when including catch-up contributions) or 100% of the participant's compensation. In 2022, the limit is $61,000 for participants 49 or younger ($64,500 for participants age 50 or older).
Are There Any Penalties?
Outside of vesting considerations, there is no distinction between employee contributions and matching contributions from an employer, so penalties for withdrawing funds before age 59 1/2 apply. In that event, the participant would pay an additional 10% in taxes in addition to the standard tax rate on the withdrawal. A 6% penalty also applies to any amount contributed to a 401(k) that exceeds the annual contribution limit. The penalty will continue to accrue until the excess amount is withdrawn from the 401(k), so if you do happen to over-contribute in any given year, it is very important to withdraw the excess amount as soon as possible.
No penalty is paid for qualified rollovers, which involve transferring a balance from one plan to another when changing employers.
- Many employers match all or part of employee 401(k) contributions.
- Taking advantage of matching funds increases overall compensation for employees.
- Employees often are not fully vested in employer contributions until they have worked with the company for a specified period of time.
- For 2022, maximum contributions per year are $20,500 for employees 49 or younger or $27,000 for employees 50 or older.