How Does 401(k) Matching Work?

If you contribute to a 401(k) or similar plan, your employer may match some of your contributions. This is free money and should be included in the total amount that counts towards the yearly limit. If you don’t include this as part of your contribution, you could miss out on matching funds from your employer and end up paying taxes twice on those dollars: once when they go into the account and again when they’re distributed later.  401(k) plans are an excellent way for many people to save for retirement; however, there are limits as to how much can be contributed each year. As an employee who makes contributions through payroll deductions, it’s important that you understand what factors will affect how much you can contribute.

Employer Match Limit Explained

An employer may choose to match a percentage of what an employee contributes to their 401(k) account. If the employer chooses to do so, they must inform employees in writing. It’s important to check your employee handbook or personnel policies to determine whether or not your employer offers matching contributions and what the details are. Employers can set a cap as to how much they will contribute towards an employee’s 401(k) account; this usually does not exceed 5% of the employees’ pay. However, employers may also include matching funds in lump-sum payments throughout the year. This means that there is no limit on when you can receive your employer’s matching funds. For example, if your employer matches 50% of employee contributions up to 6%, the cap you should be looking for is 3% (50 percent of 6 percent).

How Does the Employee Contribute to Their 401(k) Account?

Employee contributions are separated by pre tax (salary deferrals) and after-tax (Roth). Pre Tax salary deferrals reduce your taxable income for that year, while Roth contributions do not affect your taxable income. The amount of money you set aside in pre tax contributions will not increase your taxable income for that year, while the amount of money available to you in Roth contributions may be reduced by any income and employment taxes.

Why Do Some Employers Offer a 401(k) Matching Contribution?

A less common reason that an employer may choose to contribute to an employee’s 401(k) account is that they feel it would be beneficial in attracting and retaining quality employees. Employees who are educated about the benefits of saving for retirement tend to make responsible decisions when it comes to managing their money; employers can benefit from educated workers who want to be financially secure in their later years. A 401(k) match is another way for employers to show appreciation and support the efforts of their employees, so if you have a choice between companies offering a 401(k) match or not, it’s a good idea to choose the company that does.

The Disadvantage of Contributing to a 401(k)

The 401(k) is a viable retirement savings option because of the tax breaks and tax-deferred growth it offers. Contributions to a traditional 401(k) do not affect your taxable income for that year, but the money you contribute will grow tax-free until you begin pulling it out in retirement. If you withdraw funds from a standard 401(k) before you reach the age of 59-1/2, it is considered a distribution and will be subject to ordinary income tax plus a 10% penalty. One of the major disadvantages of participating in your company’s 401(k) plan is that you may lose sight of where your money is going. If you spend all of your pre tax dollars each year, you will have nothing left to save. Another disadvantage of using the 401(k) is that there are strict limitations on how much you can contribute. If you want to be able to contribute more towards your retirement, a Roth IRA may be a better option for you.

Why Should an Employee Contribute to Their 401(k) Account?

The biggest advantage of the 401(k) is that it offers tax-deferred growth, so you will not be taxed on any interest or dividend income until you withdraw the funds at retirement. If managed correctly, a 401(k) can become a powerful source of retirement income over time. The longer your money has to grow, the more you will have when it comes time for you to retire. As mentioned, many companies match employee contributions up to a certain limit in order to encourage people to save for retirement. The employer may match 100% of your contributions until a certain percentage of your salary is reached, at which point the match will start to decrease.

The Bottom Line

If your employer offers a 401(k) match, it is in your best interest to participate so you can take advantage of this benefit. Even if you are only able to contribute 1 percent of your salary, every dollar counts towards your retirement savings. When deciding how much to contribute each month, don’t forget that the money will not be available to you until retirement, so you don’t want to contribute more than you would be comfortable with losing. While a 401(k) can be a powerful retirement savings tool, there are several disadvantages to consider before participating in your company’s plan. The money you contribute will not have any impact on your taxable income for that year, and there are strict limitations on how much you can contribute. Finally, if you withdraw funds from a traditional 401(k) before you reach the age of 59-1/2, you will be subject to ordinary income tax plus a 10% penalty.

Typically, employers will match 50 percent of their employees' contributions up to 6-8% of their salary. Some companies choose not to offer a 401(k) match, but it is still in your best interest to participate because you take advantage of the tax benefits and you can save for retirement even if your employer does not match your contribution.
You can either have your employer deposit a percentage of each paycheck directly into your 401(k) or you can choose to have it put in on a pre tax basis before taxes are taken out. You will need to verify this with your HR representative.
The main benefit of participating in a 401(k) is that you can take advantage of tax breaks, tax-deferred growth, and an employer match. If you withdraw funds before retirement, you will be subject to ordinary income tax and a 10% penalty. For these reasons, you should contribute as much as possible to your 401(k) in order to maximize the benefits and minimize the penalties.
You should save for retirement by participating in a 401(k). Since your contributions are taken out of each paycheck before taxes are taken out, you won't have to worry about owing additional money when you file your income taxes each year. In addition, many employers offer a match-up to a certain amount of contributions from their employees, which is free money that can help boost your retirement savings even further.
Employees are allowed to save up to $16,500 in a 401(k) plan per year. You can change your contribution amount at any time, but it's important to remember that your contributions must be made before taxes are taken out of your paycheck. For example, if you earn $40,000 per year and put 5% of your salary ($2,000) into a 401(k), the contribution will only actually be 4.6% of your annual income because that portion is excluded from taxable wages.

True Tamplin, BSc, CEPF®

About the Author
True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.