A 401(k) is a type of qualified retirement plan offered by many employers that allows an employee to deposit pre-tax dollars from each paycheck into a retirement account. The employer may match a set percentage of the employee's contributions. When the employee retires, the contributions and investment growth can be withdrawn to provide income or supplement Social Security benefits.
- Choosing a 401(k) over a traditional pension puts the onus of contributing and investing for the future on the employee, not the employer.
- If your employer matches your 401(k) contributions make sure to take advantage of the benefit.
- The IRS doesn’t require employers to match employee contributions, though many do.
- Having a retirement plan helps attract and keep talented employees.
- Employers receive tax benefits for contributing to 401(k) accounts.
Pension Plan vs. 401(k)
These days, most private-sector employers prefer defined contribution plans like the 401(k) to the traditional pension that the company entirely funded. The pension plan was a monthly payment for life, in an amount based on the employee’s tenure and salary history. Aside from the obvious financial burden, the plan required employers to manage a retirement investing and payment system.
In contrast, 401(k)s and other defined-contribution plans put the onus of contributing and investing on the employee. They don't guarantee (or "define") a set payout at retirement. Ultimately, this ends up being far more cost-effective for the employer.
The IRS doesn't require matching the employee's 401(k) contributions, but many employers do so. The "company match" is a crucial selling point inside the company. A certain percentage of a firm's employees must participate for a plan to be considered legitimate by the IRS.
Typically, the company's contribution level is tiered: A generous match might include a dollar-for-dollar match on the first 3% of the employee's deposit, then 50 cents on each dollar of the next 3%, up to 6% of employee contributions in total, for example.
In 2019 (the most recent figure available), the average employer 401(k) match contribution was 4.7% of an employee's salary.
The Bottom Line
The employer match also is an attractive benefit for recruitment. If an employee has offers from more than one company and all else is equal, the 401(k) contribution matching could become a factor in choosing one firm over another.
Also, employers receive tax benefits for contributing to 401(k) accounts. Specifically, their matches can be taken as deductions on their federal corporate income tax returns. They are often exempt from state and payroll taxes as well.
Charlotte Dougherty, CFP®
Dougherty & Associates, Cincinnati, OH
Employers offer benefit programs to help employees feel valued and build financial security for themselves and their families through tax-advantaged savings. While it is costly for the employer to manage, oversee, and test the plan, the overriding value of offering a 401(k) match is to earn the goodwill and loyalty of employees and provide a meaningful benefit.
Employees can grow their savings in a tax-deferred account and multiply their savings by way of the employer’s matched dollars, which are also tax-free at the time of contribution. If you have a 401(k) matching plan as a part of your employee benefits package, it is wise to make the most of it as it is an important tool for building net worth and financial independence for your retirement years.