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What Is a 401(k) Match?

A 401(k) is a retirement plan sponsored by employers that allows employees to contribute a part of their pre-tax earnings.

A 401(k) match is when employers add money to your 401(k) plan on top of the amount you added. Usually, the total amount of employer-matching contributions is a percentage of your income. — Worldculturepost

Key Takeaways

  • Employers can match some or all of your 401(k) contributions, depending on a specific percentage of your income or your contributions.
  • Using matching funds boosts overall compensation for employees and is free money from your employer.
  • For 2022, the maximum contributions per year are $20,500 ($22,500 in 2023) for employees 49 or younger.
  • Employees often do not fully own employer contributions until they have stayed with the company for a certain period of time.
What Is a 401(k) Match

How a 401(k) Match Works

A 401(k) is a retirement plan sponsored by employers that allows employees to contribute a part of their pre-tax earnings. The contribution usually corresponds to a percentage of an employee's income, and employers who provide matching contributions do so up to a certain percentage.

Employers can design their plans differently. Some may let employees choose a fixed dollar amount instead of a percentage of earnings, and some matching contributions may be based on a percentage of the employee's contribution. However, many plans demand that you contribute a minimum amount or percentage of your income to be eligible for the employer match.

When you enroll in your employer's 401(k) plan, you'll decide how much money you want to contribute from each paycheck, and that amount will be subtracted before income and payroll taxes are calculated. Your employer's matching contribution will be computed automatically, based on its policy.1

With the advantages of compound returns, your 401(k) match, along with returns, can have a significant impact in a few short years. The $50 per week that your employer contributes adds up to $2,600 per year and $26,000 within ten years—and that's before investment returns.

Examples of a 401(k) Match

An employer may match 50% or even 100% of what an employee contributes up to a certain percentage of the employee's income. Other plans may set a dollar amount limit on the employer's contributions.

Example: 100% Match

Suppose an employer matches 100% of your contributions up to 5% of your income, but you must also contribute 5% to qualify for the match. You are paid $2,000 bi-weekly and contribute 5% or $100 ($2,000 * 5%).

Your employer would also contribute $100 every other week as long as you maintain your contributions. As a result, you'd see your 401(k)'s balance increase by $200 per pay period even though you only had $100 subtracted from your paycheck.

Example: 50% Match

Suppose your employer matches 50% of your contributions up to 5% of your income. In this example, you would still be required to contribute 5% of your income to qualify for the match. If you're paid $2,000 bi-weekly, your 5% contribution would still be $100 ($2,000 * 5%).

However, your employer would contribute $50 every other week ($2,000 * 2.5%). As a result, you'd see your 401(k)'s balance increase by $150 bi-weekly even though you only had $100 subtracted from your paycheck.

Vesting and 401(k) Match

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 worked 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 promote 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 set up a graded vesting plan that gives you more access to the matched funds the longer you stay with the company, until the fully-vested date.

For example, an employee might not be able to join the 401(k) until she has worked for the company for one year. Her company might let her 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.3

Is a 401(k) Match Worth It?

There are several reasons to use a 401(k) match, including the contributions by your employer for your retirement is free money. The IRS sets the annual maximum contribution limits for 401(k) plans each year.

  • 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."
  • For 2023, you can contribute up to $22,500 of pretax income to a 401(k). If you are 50 or older, you can contribute another $7,500 in catch-up contributions.

However, matching contributions don't lower the amount you can contribute to the plan from your income. When adding employer contributions, the maximum amount that can be contributed by both the employer and the employee is as follows:

  • In 2022: $61,000 ($67,500 including catch-up contributions).
  • In 2023: $66,000 ($73,500 including catch-up contributions).
  • The total amount contributed must be less than 100% of your compensation.

Also, matching contributions grow tax-free while in the 401(k) plan. In other words, you don't pay any capital gains taxes each year on investment returns within the plan. The funds are taxable only when money from the plan is taken out and are taxed based on your income tax rate at the time of the withdrawal.

Are There Any Penalties?

Apart from vesting considerations, there is no difference between employee contributions and matching contributions from an employer, so penalties for taking out funds before age 59 1/2 apply.

In that case, the participant would pay an extra 10% in taxes on top of the standard tax rate on the withdrawal. A 6% penalty also applies to any amount added to a 401(k) that goes beyond the annual contribution limit.

The penalty will keep accumulating until the excess amount is taken out from the 401(k), so if you do happen to over-add in any given year, it is very important to take out the excess amount as soon as possible.

No penalty is charged for qualified rollovers, which involve moving a balance from one plan to another when switching employers.

Frequently Asked Questions (FAQs)

What does a 5% 401(k) match mean?

A 5% match for your 401(k) means your employer is providing a 100% match on all your contributions each year, up to a limit of 5% of your annual income.

For example, if you earn $40,000 per year, the maximum amount your employer would match is $2,000, but you must also add $2,000 to qualify for the match. Be sure to read the rules for your plan since matching percentages can differ.

Is a 401(k) plan match worth it?

Yes. The employer match is basically free money that your employer is putting into your retirement account as long as you contribute the minimum required to qualify. Your 401(k) funds, including the matching contributions, grow tax-free, and your contributions are made on a pre-tax basis, meaning they reduce your taxable income in the year of the contribution.

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