401(k) Tips

How Does 401k Matching Work?

Does your new employer offer 401(k) matching? Find out how 401(k) matching works, and everything you need to know about this “free money”.

3 min read

If you recently changed jobs or started a new job, your employer will set up a 401(k) retirement account for you. A 401(k) account allows employees to make tax-deferred contributions through elective deferrals. An employer may also offer 401(k) matching as part of the company’s compensation plan to retain top employees in the company.

An employer with 401(k) matching makes contributions to the employee’s 401(k) account, based on the amount contributed by the employee to the plan. The employer can offer either partial or full matching of your contributions, depending on the company’s policy. The employee can get full ownership of the matched contributions either immediately or after a certain period, depending on the company’s vesting schedule.

How 401(k) Matching Works

The terms of a 401(k) plan vary across employers, and you will have to discuss with your employer to know the specific details of the employer’s 401(k) plan and the matching program.

The sponsoring employer determines the terms of its 401(k) matching program, but it must observe the required contribution limits rules provided by the ERISA act. Generally, the employer may use either of these two types of matching methods:

Partial Matching

If your employer offers partial matching, it will match part of the money you put in to a 401(k) account, up to a specific limit. Most employers provide a 50% match of the employee’s contribution, up to 5% of the paycheck, but this may vary across employers. In simple terms, your employer will match half of what you put in, but not more than 2.5% of your salary.

For example, if you earn $80,000 a year, and the employer offers a 50% partial match up to 5% of your salary, it means that that employer will contribute $2,000 or 50% of the money you contribute to your 401(k) plan. Partial matching does not limit the amount you contribute; you can contribute more than 5%, but the employer will only match up to the 5% mark. If you decide to contribute more than 5% of your salary, you should watch out not to exceed the IRS contribution limits for the year.

Dollar-for-Dollar Matching

An employer may also offer full matching or 100% match of your contributions, up to a certain limit. If your employer offers dollar-for-dollar matching up to 6%, it will contribute an amount equal to your contribution up to 6% of your salary. If you contribute 3%, the employer will also contribute 3% of your salary. However, if you decide to contribute 7% of your salary, the employer will only put in 6%, which is its set limit.

401(k) Matching Contribution Limits

When determining how much to contribute to your 401(k) plan, you should consider the IRS annual contribution limits. For 2021, you are allowed to contribute up to $19,500, up from $19,000 in 2019. If you are 50 or order, this limit increases to $26,000, including $6,500 in catch-up contributions.

For the combined employer and employee contribution, the maximum limit is $58,000 for 2021 or $64,500 for participants who are 50 or older.

Do I Qualify for My Employer’s 401(k) Matching Program?

If you started a new job, you should find out if your new employer has a 401(k) matching program and the eligibility requirements for new employees. Employee eligibility is at the employer’s discretion, and most employers may require the employee to have worked for the company for a specific period to get the benefit. Some companies may also offer 401(k) matching to the top executives as part of the employee compensation plan to retain top talents.

If you were recently enrolled in the employer's matching program, but don't know how it works, you should talk to the human resource manager or 401(k) plan administrator to get more information on the matching program. You should ask about the type of matching offered, whether it is a partial or full match, and the matching limits. You should contribute the highest amount that allows you to collect the full employer's match, without stretching your finances beyond what you can afford.

Do Penalties Apply?

The combined 401(k) contributions from the employee and the employer are subject to penalties for early withdrawal and excess contributions above the IRS contribution limits. If you withdraw funds before you turn 59 ½, the IRS imposes a 10% penalty tax subject to certain exemptions. In this case, you would pay an extra 10% tax above the regular income taxes on withdrawals.

The IRS also imposes a 6% penalty on any amounts contributed to a 401(k) above the annual contribution limits. If the employer's matching contributions push the contributions above the set limit, you will be required to pay penalties on the excess amount, and the penalties will continue to accrue until you withdraw the excess amount. There are no penalties for moving 401(k) to an IRA when you quit or leave your employer.

401(k) Vesting Schedules: What Are They?

Some employers have a vesting schedule for their matching program. This schedule determines the portion of the employer’s contribution that is fully owned by the employee based on the number of years they have worked for the company.

While your contributions fully belong to you, the employer’s contributions do not fully belong to you until you meet certain conditions. You may forfeit some or all the employer’s contributions if you resign or are terminated before a specific number of years have elapsed.

The main types of vesting include:

Immediate Vesting

Immediate vesting gives the employee full ownership of the employer’s matching contributions as soon as they are deposited in their 401(k) account.

Graded Vesting

This vesting schedule gives employees gradual and increasing ownership of the employer’s contributions until it reaches 100% ownership. An example of a six-year graded vesting schedule is as follows:

Year 1: 0%

Year 2: 20%

Year 3: 40%

Year 4: 60%

Year 5: 80%

Year 6: 100%

If an employee leaves the employer after four years of employment, they will only get 60% of the employer’s matching contributions. If the employee leaves after 6 years, he/she gets to retain 100% of the matching contributions. Federal regulations require that vesting schedules cannot exceed 6 years.

Cliff vesting

This vesting schedule gives the employee 100% ownership of the matching contributions after a specific period of employment, usually below 3 years. For example, if the employer requires two years of active employment, an employee must reach the fully vested date to get full ownership of the employer’s contributions. If the employee leaves the company after one year, he/she will forfeit all of the employer’s contributions.

How Does 401(k) Matching Work for Roth 401(k)?

If you contribute to a Roth 401(k) account, your employer will match your contributions at the same rate as traditional 401(k)s. A Roth 401(k) has a lot of similarities with a traditional 401(k) plan, except that its contributions are taxed upfront, and you won't be required to pay taxes on withdrawals.

If your employer matches traditional 401(k) plans, it should offer a match for Roth 401(k) plans. When matching Roth 401(k) contributions, the contributions are made before taxes are paid for it. Therefore, you will owe taxes on the portion of the employer's contribution when you take a distribution. In simple terms, the employer's matching contributions go into a traditional 401(k), and you will be required to pay taxes on the employer's contributions and any investment growth associated with the match when you make a withdrawal.