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. However, many plans require that you contribute a minimum amount or percentage of your salary in order to qualify for the employer match. 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.
Examples of a 401(k) Match
An employer might match 50% or even 100% of what an employee contributes up to a certain percentage of the employee’s salary. Other plans might impose a dollar amount limit on the employer’s contributions.
Example: 100% Match
Let’s say an employer matches 100% of your contributions up to 5% of your salary, 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 continue your contributions. As a result, you’d see your 401(k)’s balance grow by $200 per pay period even though you only had $100 deducted from your paycheck.
Example: 50% Match
Let’s say your employer matches 50% of your contributions up to 5% of your salary. In this example, you would still be required to contribute 5% of your salary 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 grow by $150 bi-weekly even though you only had $100 deducted 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 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. 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?
There are several reasons to take advantage of a 401(k) match, including the contributions by your employer for your retirement is free money. The IRS establishes 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 reduce the amount you can contribute to the plan from your salary. When including 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 gains within the plan. The funds are taxable only when money from the plan is withdrawn and are taxed based on your income tax rate at the time of the withdrawal.
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. For example, if you earn $40,000 per year, the maximum amount your employer would match is $2,000, but you must also contribute $2,000 in order to qualify for the match. Be sure to read the rules for your plan since matching percentages can vary.
