A 401(k) plan helps you save for retirement, often with the generous assistance of your employer. The 401(k) account represents a valuable benefit that not only earns income as its investments (hopefully) gain in value, but is also blessedly tax-free until you start to withdraw. A matching contribution from the employer -- also known as "free money" -- is another benefit.
Matching Contributions and Limits
A matching contribution from an employer usually is based on the amount of your own deposit into the 401(k) account. The employer is not obligated to contribute nor is he obligated to any specific percentage; according to the Internal Revenue Service rules, however, he can't contribute more than 25 percent of your salary. The IRS places a limit on employer contributions to all 401(k) accounts in a single year. As of publication, that limit reached $17,500. When you hit 50 years of age or older, the IRS allows an additional "catch-up" contribution, bringing the limit to $23,000. Combined with the employer contribution, the overall contribution is limited to $51,000 as of publication.
It's common for employers to contribute a percentage amount based on part of your salary. For example, your boss might kick in 50 percent of your own contributions, up to 10 percent of your total salary for the year. The most common formula, as reported by the Society for Human Resource Management in late 2013, is a dollar-for-dollar match on the first 6 percent of employee contributions. These formulas give employees an incentive not only to save as much money as possible, but also to strive for a higher salary, as the contribution will rise proportionally with the salary amount.
The contributions you make to a 401(k) are "pre-tax," meaning they are not taxed as ordinary wages before they go into your account. Another phrase for your contribution is "elective deferral," meaning you choose to defer paying taxes on the money before you withdraw it. The employer also is allowed to deduct matching contributions from his business income for tax purposes but still must withhold payroll taxes from the matches for Social Security and Medicare. The IRS also allows Roth 401(k)s, to which you contribute after-tax money but can avoid taxes on the gains in the account when you withdraw.
Employers can set "vesting" rules on their contributions to your 401(k). This means you may have to remain with the same employer for a minimum period of time before the employer contributions are fully credited to the account. Leaving the job before the contributions fully vest would mean forfeiting a part or all of the employer matches -- but your own elective deferrals, as a part of your own compensation, would not be affected.
Founder/president of the innovative reference publisher The Archive LLC, Tom Streissguth has been a self-employed business owner, independent bookseller and freelance author in the school/library market. Holding a bachelor's degree from Yale, Streissguth has published more than 100 works of history, biography, current affairs and geography for young readers.