A 401(k) plan is a retirement savings vehicle sponsored by a U.S. company for its employees. Since its advent in 1978, this type of plan has grown increasingly prevalent, largely due to the profound impact it can have on an employee’s ability to save for retirement.
The 401(k) offers savers two powerful benefits — tax deductibility on annual contributions and tax deferred growth on the accumulation of invested funds. Collectively, these benefits can considerably magnify an individual’s retirement savings, assuming sensible investment selections.
Some 401(k) sponsors augment these tax-related benefits with an additional feature — a 401(k) match.
What Is a 401(k) Match and How Does It Work?
A 401(k) match is essentially a form of compensation, but it also serves as an incentive for an employee to save for retirement. An employer match complements the employee’s contribution, resulting in an amplified rate of savings. For this reason, a match is often referred to as “free money.”
Note that the employer match occurs only when an employee contribution is made.
Let’s take a closer look with a real-world example, using the following IRS-stipulated limitations:
- For 2021, the annual 401(k) contribution limit for an individual under the age of 50 is $19,500.
- The annual limit on total employee and employer contributions is $58,000 (as long as total contributions do not exceed 100percent of the individual’s compensation).
Few employers can afford to push a participant’s total plan contribution to the $58,000 limit. However, many offer a generous match.
Match structures vary widely, but from personal experience, I can attest to the following formats:
- 50 percent of contributions up to 6 percent of the employee’s eligible compensation (3 percent maximum match)
- 100 percent of contributions up to 7 percent of the employee’s eligible compensation (7 percent maximum match)
Let’s take a look at how the first one works.
Consider John Smith, a 30-year-old employee who earns $100,000 annually and is committed to maximizing his allowable 2021 contribution of $19,500 (via bi-weekly payroll deductions).
Each pay period, John contributes $750 ($19,500 ÷ 26 = $750).
Alongside John, his employer contributes an annualized match of $3,000 — which reflects the employer’s commitment to contribute 50 percent of John’s contributions up to 6 percent of his salary ($100,000 × 0.50 × 0.06 = $3,000).
So, in this case, the employer contributes $115.38 ($3,000 ÷ 26 = $115.38).
This example is summarized in the table below.
Employee and Employer Contribution in a 401(k) Match Program
As illustrated, the match feature has enabled John to increase his annual savings from $19,500 to $22,500.
This “free money” feature is certainly an enticing reason to save for retirement through participation in a 401(k) plan. That said, aside from the considerations previously discussed, there are a few other factors to be aware of when assessing a match.
First of all, many plan sponsors maintain a vesting schedule, which requires an employee to stay with the company for a specific period of time before the employer contributions are truly his or hers.
Secondly, a match is not necessarily set in stone. A company can turn a match off during difficult or highly uncertain times.
Unfortunately, many people recently experienced this due to the economic fallout from the COVID-19 pandemic. The good news is that the match can just as easily be turned back on when the horizon clears.