How 401(k) Matching Works

Retirement planning can be tricky. Especially if you aren’t familiar with the different options available out there to help you reach your goals. Retirement involves a person making the decision to leave the workforce for good. However, once someone loses that income that comes from their job, it can be hard to keep up with bills and other expenses. That is why people save for their retirement. There are a lot of saving opportunities to consider when it comes to retirement. However, a popular option is a 401(k) plan.

What are 401(k) Plans?

401(k) plans are retirement investment accounts that employers offer to their employees. These plans use the funds that  are deposited into them towards investments. That means they can grow! The best part? Sometimes an employer contributes the same amount that an employee puts in. Other times, they may choose to contribute a partial amount or none at all. It just depends on the employer! The funds that employees put in are known as contributions while the funds they take out are known as distributions. Basically these are just fancy terms for saying deposits and withdrawals. The funds that are deposited into the account can go towards a variety of investment options. There are two main types of accounts when it comes to 401(k) plans. There is a:

  • Traditional 401(k)
  • Roth 401(k)

Regardless of whether it is a Traditional 401(k) or a Roth 401(k) there are still some rules that apply. For example, there are contribution limits that people must follow. In 2021 the contribution limits for a 401(k) were:

  • $19,500 for people younger than 50 years old
  • $26,000 for people older than 50 years old

It’s also important to keep in mind that contribution limits for 401(k) plans can change every year! For example, in 2022 the contribution limits are:

  • $20,500 for people younger than 50 years old
  • $27,000 for people older than 50 years old

Different Types of 401(k) Accounts

Like we said earlier there are two main types of 401(k) accounts. It is important to understand the difference between these two accounts especially since each option comes with its own set of pros and cons.

What is a Traditional 401(k)

Let’s start off by getting a better understanding of what a Traditional 401(k) account is. This type of account uses pre-tax dollars. Since the account uses pre-tax dollars, that means the contributions can be seen as a tax deduction! This would reduce the overall amount of taxable income that you are responsible for (only for the year that you deposit the funds). For example, let’s say you made a deposit of $1,000 in 2021 and your income for 2021 was $51,000. You could get a $1,000 deduction and only be responsible for paying taxes on $50,000. For this type of account there are rules that are important to remember (besides the contribution limits listed above). For example, you will have to take out required minimum distributions (RMDs) once you are 72 years old.

Taxes of a Traditional 401(k)

It’s important to especially pay attention to the tax side of things when learning about a Traditional 401(k). Since employees will get the tax benefit when they deposit funds, they will need to deal with taxes later on down the line. When you make withdrawal (known as a distribution), you can expect the funds to be taxed at the standard income tax rate.

What is a Roth 401(k)

Now that you have a better understanding of a Traditional 401(k), let’s take a deeper look at a Roth 401(k) account. Unlike a Traditional 401(k), these accounts are funded with after-tax dollars. That means taxes (like income taxes) have already been applied by the time that an employee makes a contribution. However, even though a person may not see tax benefits right away, they will see them down the line once it’s time to take out a distribution. That’s because the funds taken out of this type of account are not subject to any additional taxes!

Understanding 401(k) Matching

One of the biggest benefits that come along with this retirement savings option is the fact that employers may match or partial match the contributions of the employee. It’s basically like free money going into your account! However, many people aren’t familiar with how these accounts work, especially when it comes to matching. It’s important to keep in mind that 401(k) plans will vary by employer. That means how they handle matching an employee’s contribution can be different. Usually you can expect to see employers match a percentage of employee contributions up until a specific portion of the overall salary. Another common way that employers handle 401(k) matching is by choosing to match employee contributions up until a certain dollar limit (instead of looking at the employee’s salary).

How 401(k) Matching Works

We know we may sound like a broken record but understanding 401(k) accounts can be confusing so repetition is key! Since this plan can be different from one plan to the next depending on the employer, you will want to confirm with your employer on specific terms of the option they provide. However, both you and your employer will need to follow contribution limits that are set (the same ones we spoke about earlier!).

401(k) Matching Examples 

Let’s take a look at an example to get a better understanding of how you may see an employer match your 401(k) contributions. For example, let’s say that your employer will match 100% of your contributions every year up to a certain dollar amount. The limit they set is $4,000. That means, if you contribute $5,000, they will only contribute $4,000 even though they technically contribute 100% of what you put in. That’s because of the limits they have in place!

Let’s take a look at another example. More commonly, employers will follow a partial match setup. For example, let’s say your employer matches 50% of your contributions. That means if you contribute $5,000 to your 401(k), they will only contribute $2,500.

Understanding a 401(k) Vesting Schedule

Another important factor to be aware of when it comes to a 401(k) account is the plan’s vesting schedule. A vesting schedule determines how much ownership you have of employer contributions. This depends on how many years you have been an employee. It’s important to keep this in mind because you may forfeit some (or even all) of your contributions if you no longer work for that employer before a specific number of years have passed.

Frequently Asked Questions (FAQs) About 401(k) Plans and Employer Matching Contributions

Many people have questions when it comes to 401(k) plans. That’s because many people are familiar with retirement savings options and how they work. If you have questions, you’re not alone!

Does Every Employer Match Your Contributions?

Not necessarily! How you will see an employer match employee contributions depends on the company. Each employer will have their own rules and terms of the 401(k) plan they offer their employees. However, it is not uncommon to see employers provide partial matching or even full matching (up to a specific limit).

Is Dollar for Dollar Match Common?

When there is full 401(k) matching (instead of partial matching), that means contributions are matched dollar for dollar on what employees put in (up until limits are met). Every employer is different but it can be hard to find plans that don’t offer partial matching since they provide so much support.

Are Employer’s Matching Contributions Going Past Limits?

No! When looking at employer’s matching contributions of their employees, they will still be limited by the IRS limits even if they have none themselves. The best way to confirm what limits you may encounter is by checking with your employer specifically.

Bottom Line

When people start planning their retirement savings, it can be daunting and stressful. Luckily it doesn’t have to be! There are a variety of accounts out there that can help people reach their goals. One popular option is a 401(k) plan. 401(k) plans are retirement investment accounts that employers offer to their employees. One of the best parts of these accounts is that sometimes an employer contributes the same amount that an employee puts in. That means you basically get free money put into that account! There are two main types of accounts when it comes to 401(k) plans. There is a:

  • Traditional 401(k)
  • Roth 401(k)

Traditional 401(k)

A Traditional 401(k) uses pre-tax dollars. Since the account uses pre-tax dollars, that means the contributions can be seen as a tax deduction! This would reduce the overall amount of taxable income that you are responsible for (only for the year that you deposit the funds). Since employees will get the tax benefit when they deposit funds, they will need to deal with taxes later on down the line. When you make withdrawal (known as a distribution), you can expect the funds to be taxed at the standard income tax rate.

Roth 401(k)

On the other hand, a Roth 401(k) is funded with after-tax dollars. That means taxes have already been applied by the time that an employee makes a contribution. However, even though a person may not see tax benefits right away, they will see them once it’s time to take out a distribution. That’s because the funds taken out of this type of account are not subject to any additional taxes!

One of the biggest benefits that come along with a 401(k) is the fact that employers may match the employee contributions. Regardless of the type of 401(k) account, matching will depend on the employer. If you want to know what opportunities are available to you then you will want to confirm with your employer! Take your time, and know that planning for retirement doesn’t need to seem as hard as it does.

Article References

https://www.investopedia.com/articles/personal-finance/112315/how-401k-matching-works.asp

https://www.myubiquity.com/business/average-company-401k-match-in-2022/

https://www.investopedia.com/terms/1/401kplan.asp#toc-traditional-401k-vs-roth-401k

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