How Does Employer 401(k) Matching Work?

In addition to making your own contributions to your 401(k) account, your employer may also contribute funds to help you prepare for retirement. Not all employers offer this benefit, but if yours does, then it’s definitely something to take advantage of. Here’s everything you need to know about employer 401(k) matches to understand how they work and how to get the most out of your program. Find out what to look for from your own employer and what to expect further down the road when it comes time to make withdrawals.

Matching Contributions Explained

An employer match is when your company contributes money to your 401(k) based on the amount of money that you put in using your own funds. There is, however, a limit to how much they’ll match. In most cases, it’s capped at a percentage of your annual salary. For example, if you contribute 10% of your salary each year but the employer maximum is at 5%, you’ll only get matched funds up to that threshold. 

Investing in a 401(k) is already a smart choice because your contributions are tax-deferred, meaning you don’t have to count the money you put in as part of your annual income for the year — up to a limit, that is (more on that shortly). If you combine those tax-deferred contributions with the fact that you’re getting extra cash invested through your employer, you can really maximize your retirement savings. 

Common Calculations for Employer Match

One of the most common ways employers set maximums for 401(k) matching is using a percentage of your salary. Another method is to match a percentage of your own contribution, such as 25% of your own match, up to a certain dollar amount. 

It’s usually easier to take full advantage of the first scenario because you just take the maximum percentage of your salary that your employer matches, then divide that by the number of paychecks you receive each year. That’s the minimum you need to contribute to get the largest possible match.

Here’s how that works in a hypothetical situation.

Say your annual salary is $100,000 and your employer matches up to 5% of each employee’s contribution every year. You need to contribute at least $5,000 each year (or about $208 every biweekly paycheck) in order to get the maximum amount of money from your employer. 

Now let’s compare that to the second scenario in which your employer matches a percentage of your match, up to a maximum amount each year. If you only contribute the same 5%, your employer only contributes a quarter of that, which comes out to $1,250 a year. You’d have to contribute a lot more to your own plan in order to reach the maximum employer match, whatever it may be. 

Limits on Annual Contributions

The IRS does impose a limit on how much you can contribute to your 401(k) each year, which they refer to as elective deferrals. For 2019, the amount is $19,000. If you’re over 50 years old, you can contribute an additional $6,000 that is considered a catch-up. That brings your total up to $25,000 for the year.

Also note that the limits apply to all of your collective 401(k)s, not each one (if you happen to have more than one). Additionally, these numbers typically increase a small amount each year to account for the increase in cost of living, so it’s smart to check the latest IRS limits for each tax year. For example, the 2018 401(k) contribution limit was $18,500 so there was a $500 increase to the limit for 2019. 

The good news is that employer contributions are not included in your personal contribution limits. The $19,000 maximum only applies to what you contribute each year.

Why You Should Max Out Your Employer Match

Most experts agree that if your employer offers a matching contribution on your 401(k), you should make sure you invest enough yourself to get the most out of them. After all, an employer match boils down to getting free money. 

Do this before you start contributing to other places like an IRA, even if it does come with certain tax advantages. Plus, you may not even qualify for an IRA depending on  how much you earn each year. In either case, prioritize your 401(k) contributions when you have the opportunity to grow your investments with an employer match. 

Of course, you also need to fully understand the details of your employer match. While it’s helpful to review example scenarios, there’s no better source than your own employer’s materials. If necessary, contact your HR representative to clarify any questions you have. 

You may also weigh how long you plan to stay at the company against the length of their vesting schedule. While an involuntary departure is beyond your control, you may already have a plan of how long you want to stay there before moving, going to graduate school, or any other life event. If you’re fairly sure you won’t last until your vesting period, you may be less concerned about meeting those matching limits.

Understanding Your Vesting Schedule

Being vested in your 401(k) means that you have complete ownership of the funds in your account. And while it’s true that you’re automatically fully vested in any contributions you make to your 401(k), this isn’t always the case with your employer match funds. 

Check to see if your plan comes with a schedule that dictates how long you have to stay at the company before becoming fully vested. If you leave before being vested, regardless of whether it’s a voluntary or involuntary departure, you could lose some of all of the funds contributed by your employer.

There are two types of vesting you may be subject to: cliff vesting and graded vesting. With cliff vesting, you get 100% access to those funds as soon as you reach a certain number of years with the company. If that minimum is five years, for example, you become fully vested at that time. 

Graded vesting, on the other hand, gives you partial vesting as you hit certain service milestones. At year two of employment, for example, you may become 20% vested, then you’d become 40% vested at year three, and so on. If you leave between years two and three, you’d only receive 20% of your employer contributions. Any gains your investments made during your employment, however, are completely vested.

How and When Taxes are Paid on 401(k) Contributions

401(k) contributions, both from you and your employer, are tax-deferred, meaning you don’t pay income tax on that money during the year you make your contribution. Instead, you pay taxes when you actually withdraw the money, whether it be during retirement or before then (though you’ll likely pay a 10% penalty if you use that money before you hit 59 ½ years old). 

When you start distributions during retirement, you’ll be taxed at whatever bracket you fall into that year. This deferment can benefit high earners because it’s likely that you’ll fall into a lower tax bracket once you reach your retirement years. 

But it can also potentially sting if your investments have grown significantly over time. Obviously, that’s the goal of investing in a 401(k), especially if you start early in your adult life and take advantage of any available employer matches throughout your career. Just don’t be surprised if you end up owing a lot in taxes in a situation where your retirement earnings boost you into a higher tax bracket. 

401(k) vs. Traditional IRA vs. Roth IRA Taxation

In order to minimize your tax burden during retirement, consider diversifying your investment accounts, especially once you’ve maxed out your employer contribution with your 401(k). Like a 401(k), a traditional IRA is tax-deferred. A Roth IRA, on the other hand, helps you mix up your tax advantages a bit.

With the Roth, your contributions are taxable with the rest of your salary the year in which you make the contribution. As your investments grow and you reach retirement age, you can start taking distributions at age 59 ½. Once you do, you don’t pay any income tax at all — regardless of how much gains you’ve realized over the years.

Both types of IRAs come with contribution limits, which is why you can’t just pick one investment vehicle and stick with it. In fact, IRAs also come with income limits. If you currently earn more than the allowed amount, you can’t access these tax-advantaged accounts at all.

The Bottom Line

Gaining access to an employer match for your 401(k) is a major benefit that you should jump on as soon as possible. Talk to someone in HR as soon as possible to make sure you’re enrolled and getting as much out of the match as possible. Once you get set up, you can watch your 401(k) grow, knowing that a large chunk of that cash didn’t even come out of your own paycheck.