As an employee, a higher 401(k) plan match rate can translate into more free money in your retirement account. A shorter vesting schedule can mean quicker ownership of your employer’s contributions — your retirement account balance is all yours, even if you were to leave the company for a new job.
Adding the maximum amount of employee contributions gets the most out of your employer match. Employers use vesting schedules to motivate employee loyalty — the longer you stay with the company, the more of the match you get to keep. A robust plan offers a mix of stock and bond funds, including index funds with broad market exposure at a low cost. More investment options allow you to fine-tune your portfolio to your financial goals and risk tolerance.
Employees are bound by the 401(k) contribution limits set each year by the IRS. Companies can either match employee contributions dollar for dollar or as a percentage of the employee contribution. A good plan encourages employees to effectively save for retirement.
How matches work
Matching programs vary. Some are generous but with limits — you can’t contribute half your salary and expect your company to match those funds. The average match is between 4% and 6% of compensation. Anything above 5% is considered a good employer match. Some firms offer employer matching up to 25%. Under the most common option, the employee contributes more to get the maximum company match. Nonmatching contributions are made by companies even if employees don’t contribute. They come directly from the company and not through employee payroll deductions.
Workers must ensure that the funds aren’t funneled into less-than-stellar investment vehicles with high management fees. About 34% of plans provide someone who can offer investment advice to participants, but not everyone puts the advice into action.
The IRS contribution limits are adjusted annually for inflation, and if you’re age 50 or older, you can make catch-up contributions. Your employer’s contributions don’t count toward these limits. You choose how much of your contribution goes to investments in your account, usually mutual funds, but investment types include company stock, securities and annuities. With more options available, you’ll have better chances of finding a good performer with low fees.
Different kinds of plans
There are two flavors of 401(k)s:
- Traditional accounts, which use pretax dollars to reduce taxable income and tax liability. You’re liable for taxes on any withdrawals you make.
- Roth accounts, which require contributions to be made using after-tax dollars, meaning no immediate tax benefits but withdrawals are tax free.
Employers only contribute to traditional accounts. Any matching Roth contributions must be placed in a traditional 401(k) account. Most employers allow immediate participation, though a small percentage require employees to work for at least a year before receiving matching contributions.
Many employers match as much as 50 cents on the dollar, up to 6% of your salary. Most financial advisers recommend contributing enough to get the maximum match. Turning down free money doesn’t make sense unless the fund is so bad that you’re losing most of it to fees and substandard returns.
Some employers may match up to a certain dollar amount, limiting their liability to highly compensated employees, regardless of income. For instance, an employer may elect to match only the first $5,000 of your employee contributions. The IRS requires that all 401(k) plans take a nondiscrimination test annually to ensure that highly compensated employees don’t benefit more from tax-deferred contributions than rank-and-file employees.
Comparing your plan with industry averages helps you understand how your plan stacks up against others. A strong 401(k) match plan can bolster your retirement savings, adding up to a sizable nest egg over time.
Of course, this is just a summary of the complex rules surrounding retirement plans. Work closely with a qualified professional before instituting a new plan or changing a current one.