A 401(k) is a type of qualified retirement plan that exists in workplaces, in which an employee deposits pre-tax dollars from each paycheck into a retirement account and the employer often matches a specific percentage of the employee's contributions, up to a certain amount. When the employee retires, the 401(k) provides a payout that reflects the total money contributed and the performance of the invested funds.
- Choosing a 401(k) over a traditional pension puts the onus of contributing and investing for the future on the employee, not the employer.
- 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.
Many private-sector employers prefer defined contribution plans like a 401(k), using them to replace defined benefit plans—the traditional "pension," funded entirely by the company, which designated a monthly payment in retirement for life, based on the employee’s tenure and salary. This sort of plan required employers to decide where and how to invest and committed them to a certain amount of money when an employee retired. 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 the end. Ultimately, this ends up being more cost-effective for the employer.
The IRS doesn't require matching the employee's 401(k) contributions, but many employers do so, as "the company match" is a key selling point for a 401(k) (a certain percentage of a firm's employees have to participate for a plan to be considered legitimate by the IRS). Typically, the company's contribution level is tiered: 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.
The average percent of a worker's pay companies contribute to a 401(k) plan.
(Source: Plan Sponsor Council of America's 61st Annual Survey of Profit Sharing and 401(k) Plans)
Most employers match employee contributions to 401(k) plans in order to attract and retain talent. Usually, if an employee has offers from different companies and all else is equal, 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 benefit 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.