How Does 401k Matching Work?

‍What is a 401k Match?

A 401(k) is a retirement plan sponsored by an employer that their employees can contribute part of their wages into. These accounts are tax-sheltered and tax-favored depending on what type they are — typically traditional or Roth — which make them an important part of anyone’s retirement planning.

As an added incentive for you to contribute to your employer-sponsored 401(k) plan is the contribution match that some employers offer. This 401(k) match is usually represented as a percentage of your wages or salary that they are willing to match. The match then goes into your 401(k) account and, after it’s fully vested, becomes your money to use later in life when you retire.

If your employer offers a 401(k) match, it’ll typically be capped off at a percentage of your pay and they will match your contributions up to that limit. For example, if you’re earning $2,000 per pay period and the employer offers a 5% match, they will add up to $100 per paycheck into your 401(k). This is money that you don’t see hitting your bank account, nor are you taxed on it or anything like that.

But don’t forget, this is a match, not just free money. So you’ll need to contribute enough to your 401(k) yourself before they will add the matched funds. We’ll get into more detail about how the match works shortly, but this gives you a general idea so you can start understanding what a 401(k) match is.

Not all employers offer any matching contributions, and for those that do, the amount they match and the method they utilize will differ as seen above. So be sure you understand the retirement plan in your own situation and know how your employer does 401(k) matching. You always want to try to contribute at least enough to get your employers’ match because that’s just free money and no other investment will provide a guaranteed return like that.

How Does a 401k Match Work?

Now that you know what a 401(k) match is, let’s dive in a little deeper to see how 401(k) matching really works. As mentioned previously, it is up to your employer to decide to offer their employees a 401(k) match. And if they choose to, it’s also up to them how they offer their match. There are two mains ways that an employer will offer a 401(k) match — partial match or full match.

What is a 401(k) Partial Match?

As the name implies, an employer that offers a partial match will only match some of the contributions that you make, up to a certain percentage of your salary or income. The most common partial match that employers offer is a 50% match on your contributions up to whatever the maximum percentage is. Many times when employers offer a 50% match, it’ll be on your contributions up to 5-8% of your income.

Let’s take a look at an example to see how this works. Say you make the same $2,000 per pay period as above for consistency. Your employer offers a partial match that is 50% of your contributions up to 8% of your salary. The percentage of your salary is the maximum amount that they will use for their matching calculations, so you decide to contribute the full 8%. In this case, that’s $160 per pay period.

Your employer will then match 50% of your contribution, which would be 50% of $160 in this case. So they would contribute an additional $80 to your 401(k) on top of the $160 you contributed — a total of $240 per pay period getting added to your 401(k) account. Keep in mind that you can contribute as much as you like, but they will only match up to the specified percentage. So if you want to contribute 10% of your salary, they will still only match 50% of the first 8%.

What is a 401(k) 100% Match?

Now that you know what a partial match is, it might be pretty clear what a 100% match is. A 100% match — also called a full match or dollar-for-dollar match — means your employer matches your contribution fully up to a certain amount. This amount again depends on what your employer has decided on and can range anywhere from a typical 3-5% up to over 10% from extremely generous employers.

What this means is that for every dollar of your paycheck that you contribute to the 401(k), your employer will put the same amount in rather than only a percentage of that like in the previous example. Let’s run through a quick example to see how dollar-for-dollar matching can differ from a partial match.

You’re working at your job making $2,000 per pay period and your employer offers a 100% match on your 401(k) contributions up to 5% of your total salary. So every pay period, you want to get the most out of the matching and you contribute $100 to your 401(k). Your employer will then match your contribution dollar-for-dollar, and give you another $100 in your 401(k) automatically. So you have a total of $200 per pay period going into your account. Just as before, you can contribute more than that, but your employer will only match up to their maximum percentage of your income.

Which Type of 401(k) Matching is Better?

As you might start seeing from these numbers, it can be difficult really deciding which of the two plans are better than the other. In the first example with a partial match, your employer provided you with just $80 per pay period compared to the $100 per pay period that you got from the employer who offered a 100% match on your contributions.

However, your 401(k) actually grew by more in the first scenario because your own contributions were more. This is because you had to contribute 8% on your own so you could get the full amount from your employer. Whereas in the second scenario, you only needed to contribute 5% to get the bigger match.

If you are just planning on saving enough in your 401(k) to get the full match from your employer, then in many cases a partial match would be better. It incentivizes you to invest a higher percentage on your own. But if you are planning on investing a higher percentage anyway, then a 100% match might be better to get the higher amount from your employer.

These are just two examples, and every situation will be different. A general rule of thumb is to invest 10-15% of your salary, if possible, into your retirement. This will help ensure you’ll have no financial problems later in life. With that much being contributed to your 401(k), you will likely get the full amount from your employer no matter which type of match they offer. In that case, it just depends on the total dollar amount that their match comes out to that will help you decide which is the better option.

How Does Matching Work in a Roth 401(k)?

One type of retirement account that is a little different is the Roth account. Without getting too much into what a Roth 401(k) is, just know that this type of account is funded with after-tax dollars. This is the opposite of the traditional 401(k) which is funded with pre-tax dollars. The big benefit to a Roth 401(k) is that you won’t owe any taxes on the money later in life when you start using the money in retirement. So how does a Roth 401(k) affect your employer match?

The good news is that it really doesn’t change anything drastically, but it’s important to understand the difference. First and foremost, when you fund the account with after-tax dollars, you need to ensure that your contribution is still high enough to get the employer match. 5% of your salary coming out of your check after taxes will have a bigger difference on the net paycheck than 5% coming out before taxes.

The only other thing to keep in mind if you opt for a Roth 401(k) is that your contributions will be the only portion of the account that is considered Roth. Your employer match will still be considered traditional and you’ll still have to pay taxes on those portions of your earnings once you access the money later in life. This is just because you are not paying taxes on that money before it’s going into your account, so it cannot be added to the Roth balance.

You shouldn’t have too much to worry about when it comes to that, as your employer-sponsored plan will be able to handle that all for you. So if you have a Roth 401(k), just know that your employer match and that portion of your earnings will still be taxed later in life, but your contributions into the Roth portion will not be.

How Much Can I Contribute to a 401k?

When you’re planning out your 401(k) contributions, you might be wondering if there are limits to how much you can contribute and how much your employer can match. Since these are tax-favored and tax-sheltered accounts, the IRS sets the limits for these types of accounts and will typically update them every year.

For 2021, you can contribute up to $19,500 to your 401(k) plan per year. If you’re 50 years old or older, you can contribute an additional $6,500 so you can catch up, for a total of $26,000 per year.  These limits are the collective limits of all of your 401(k) accounts if you have multiple, not just per account.

Keep in mind, however, that these limits are completely independent of any other retirement account such as an IRA. So you can contribute the full amount into a 401(k) and also the full $6,000 into an IRA and there will be no issues!

As for your employer, they can add funds up to the point where the combined total between your contributions and their match is $58,000 per year or less. For the vast majority of people, this will never come into play. But it’s there for incredibly higher earners and also business owners who pay themselves as an employee while also being the owner.

What is Vesting in a 401k Match?

While you’re reading up on how your employer offers a match on 401(k) contributions, you may come across the term vesting or vested amount. This refers to the amount of money in your account that is truly yours at a given point. This is because of the company’s vesting schedule, or how long before the amount that they’ve added to the account is yours no matter what.

Vested amounts are typically based on how long you’ve worked for the company. For example, many companies will offer partial vesting annually (maybe 20% per year) until you’ve worked long enough for their match to be fully vested. Other times it’ll just be a certain number of years and then it’s fully vested.

This just means that until you’ve worked there for however many years they specify, some (or all) of their match can be taken away if you leave that company. So it’s important to know what the vesting schedule is and how that factors into your choice to join a company or to keep searching for a new job.

No matter what you do and who you work for, if your employer offers a 401(k) match, take it! You should always try to contribute at least enough to the program to get the full match from your employer. It’s free money and the easiest return on investment you’ll ever get!