A 401(k) is an employer-sponsored retirement plan that allows employees to contribute a portion of their pre-tax earnings. Some employers match employee contributions up to a certain amount, thus increasing the compensation package for participating employees.
By taking advantage of your employer's 401(k) match, you can help build savings for your retirement and increase the total value of your earnings without having to pay income tax on those earnings until later down the road. Learn about the best ways to maximize the value of your 401(k) plan and your employer's matching contribution.
What Is a 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. 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 contributed 5% of her salary, and her employer matched 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 patience, persistence, and the benefits of compound interest, your employer's matching contribution can be increased substantially with interest earnings within a few short years. The $50 per week your employer chips in adds up to $2,600 per year and $26,000 within 10 years—and that's before even calculating any interest earnings. A modest return of 5% on $26,000 would be the equivalent of another $25 per week in your account. The more your balance grows, the more your earnings from interest grow.
How employers structure their plans can vary. Some may allow employees to choose a flat dollar amount as opposed to 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.
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 your employer's policy.
For example, an employer might agree to match 100% of employee contributions up to 5% of the paycheck. So, if a paycheck is $1,000, that means the employer would match the employee 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 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 allows her to have access to only 25% of the matched contributions at the end of that second year. Her vesting increases by 25 percentage points each year until she becomes fully vested after five years as an employee.
How Much Can I Contribute?
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 2020 and 2021, you can contribute up to $19,500 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 2020 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 2021, the limit is $58,000 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 or matching contributions from an employer. So, penalties for withdrawing funds before age 59 ½ 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, 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 working with the company for a specified period of time.
- For 2020 and 2021, maximum contributions per year are $19,500 for employees 49 or younger or $26,000 for employees 50 or older.
- In 2020, employee contributions can raise those limits to the lesser of $57,000 for employees 49 or younger ($63,500 for employees 50 or older) or 100% of an employee's compensation. In 2021, the total contribution limits are $58,000 for those 49 or younger and $64,500 for employees 50 or older.