How Does 401k Matching Work?

401k Matching

If someone said they’ll give you free money, you’d be first in line, right? That’s the idea behind employer 401k matching. Employers give you ‘free money’ as a part of your compensation plan. There’s a catch, though. Your employer will deposit the money into your retirement account to match what you contribute up to a certain percentage of your income.

In this article, we’ll go over what a 401k company match is, how it works, the types, and the rules, along with an example. Our goal is to help you understand it so you can take advantage of the free money to further your retirement goals.

What is a 401k company match?

A 401k company match is a percentage of your salary your employer will match. For example, if your employer will match 4% of your salary and you make $1,500 a week, your employer would match your contributions up to $60 a week if you contribute that much.

With your $60 contribution plus your employer’s contribution, that’s $120 a week. It doesn’t sound like much, but with compounding interest, you’ll see your earnings grow faster than you anticipated. $120 a week is $6,240 a year or $62,400 over ten years, and that’s before interest. It’s a good start to your retirement savings.

How does a 401k match work?

Each employer has different 401k employer match rules. No matter the rules, though, your contributions to your 401k are pre-tax. You decide how much to contribute when you sign up for the 40kK. You can change your contributions by talking to your HR department throughout your time there too.

Let’s say you make $1,500 a week and elect a 5% contribution. Your employer would deduct $60 a week BEFORE taxes for your contributions.

Your employer’s match rules determine how and when they match your contributions. Talk to your plan sponsor or HR department about the timing of your employer’s contributions. Each employer has different employer match rules too.

Partial matching

Some employers offer partial matching. Here’s how it looks:

Your employer will match 50% of your contributions up to 5% of your salary. If you make $75,000 a year, this means IF you contribute $3,750 throughout the year, your employer will match or contribute $1,875 or 50% of your contributions up to a certain percentage of your income.

Please note, you can make larger contributions - meaning you don’t have to stop at 5% of your salary, but your employer will only match up to the specified amount. You may contribute up to the IRS limits for the current year.

Dollar-for-dollar matching

A dollar-for-dollar match uses the same idea, but it means your employer will match 100% of your contribution. Dollar-for-dollar matches have limits, too, usually up to 6% of your salary, but each employer differs.

401k employer match rules

Each employer has 401k employer match rules. Always read your paperwork and talk to your HR department to make sure you understand. A few common terms you’ll hear are vesting schedules, contribution limits, and penalties.

Vesting schedules

Vesting schedules determine how much of the employer’s contributions you keep if you leave your job. You can always take the funds you contributed, but any money your employer contributed depends on the vesting schedule.

To take 100% of your employer’s contributions, you must be fully vested. On average, this takes five years for most companies, but it’s not unheard of to be 100% vested right away. Most companies use a graded vesting schedule as it promotes employee loyalty.

Think of it this way. If a business fully vested you right away, you could make your max contribution, get the employer match and then quit, taking the money with you. But, if a company has graded vesting, you only have access to a certain percentage of the company contributions each year.

IRS contribution limits

The IRS contribution limits for retirement accounts are out of any employer’s hands. The IRS states the new limits each year. Some years the limits remain the same, while in other years they increase.

Penalties

All 401k accounts and money (employer or employee contributions) are subject to early withdrawal penalties. If you withdraw any retirement funds before age 59 ½ and it’s not an approved loan, you’ll pay a 10% penalty fee plus applicable taxes.

You’ll also pay the penalty if you contribute more than the stated IRS limits for the year. You’ll pay a 6% penalty on the amount that exceeds the current year’s limits. The penalty accrues each year until you withdraw the full amount of excess contributions.

Roth 401k

Some employers offer a Roth 401k option. 401k matching still applies just like with the standard 401k, but the taxes differ.

Rather than contributing before-tax funds like a traditional 401k, you contribute after-tax funds in a Roth 401k. It sounds like a bad idea since you’ll increase your tax liability now, but here’s where it gets good.

Your contributions AND earnings grow tax-free. If you leave the money until you are at least 59 ½, your contributions are tax-free. This includes any compounded earnings. You also don’t have to worry about Required Minimum Distributions. This is known as the IRS’s rule regarding how much you must withdraw each year, so Uncle Sam gets his portion of the taxes.

401k matching example

Let’s look at an example.

John took a job at ABC company. As a part of his compensation, his employer will match up to 5% of his salary in his 401k based on what he contributes. John is eligible to contribute to his 401k on day one, and he makes $75,000 per year.

John elects to contribute $312.50 a month, which is 5% of his monthly salary. His employer also contributes $312.50. So by the end of his first year, John has $7,500 in his 401k. However, he only contributed $3,750 because his employer contributed the other half.

Maximizing your employer 401k match

Don’t throw away free money. Use these tips to maximize your employer 401k match.

Get the full match if you can

Figure out the full amount your employer will match and situate your budget. Contribute to your 401k consistently so you get the full amount your employer will contribute.

What to do if you can’t afford to max out

If you don’t have room in your budget, rework your expenses. Where can you cut back? Look at your monthly expenses and your discretionary spending. Can you shop around for cheaper insurance, cut the cord on cable, or cut down your ‘luxury’ spending on shopping, grooming, and other luxuries?

Figure out the amount you need to meet the employer match and play with your budget to make it work. Even if you have to sacrifice, your future self will thank you.

401k matching helps you reach your retirement goals

How much should you contribute to get a full employer match, and what’s the vesting schedule? Know your 401k matching rules so you can make the most of your retirement savings.

These are the two factors you should pay the most attention to when considering your employer’s 401k. Even if you only contribute enough to get the match, you’ll double your retirement savings, and it won’t cost you any more money.

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