DEFINITION of Matching Contribution
A matching contribution is a type of contribution an employer chooses to make to his or her employee's employer-sponsored retirement plan. The contribution is based on elective deferral contributions that the employee makes.
BREAKING DOWN Matching Contribution
Generally, the employer's contribution may match the employee's elective deferral contribution up to a certain dollar amount or percentage of compensation. For example, an employer might match 50% of an employee’s contribution. It often takes several years or a vesting period for this benefit to begin. (Vesting also has strong ties to employee retention. Stock bonuses, for example, can entice valued employees to remain with the company for several years, particularly if the company is promising and might be acquired or go public in the coming year(s), which would mean the employee’s stock would multiply in value.) In some cases vesting is immediate. For example, employees are 100% vested in SEP and SIMPLE employer contributions. With regards to a 401(k), a cliff vesting or graded vesting schedule may escalate towards a full matched contribution.
Matching Contribution and Retirement Savings
With or without an employer’s matched contributions, individuals have several options when saving for retirement. As noted above, they can contribute to their own individual retirement account (IRA) or Roth IRA, along with a company’s 401(k) plan. For smaller companies, SEP and SIMPLE plans could be more effective. The most common form of a matched contribution occurs in a 401(k) plan, however. 401(k)s are qualified employer-sponsored retirement plans that employees contribute to on a post-tax and/or pretax basis. Employers may make matching or non-elective contributions to the plan on behalf of eligible employees and may add an additional profit-sharing feature.
Earnings in a 401(k) plan accrue on a tax-deferred basis. This means within a given year, an employee will not have to pay taxes on these funds; however, when she or he withdraws the amount at 59.5, the eligible retirement age, she or he pays ordinary income tax if the initial contribution is pre-tax. If the employee withdraws funds prior to 59.5 for a non-qualified reason, they could incur a 10% penalty. Individuals must also take required minimum distributions (RMDs) before they reach a certain age, generally 70½. Because of compounding, the longer these funds stay in retirement accounts, the more valuable they become. This is very important for individuals saving for retirement and a time at which they might not have steady income; however, the U.S. economy also needs to keep enough of these funds in circulation.
If the plan allows – and the employee is still employed after he or she reaches age 70½ – the RMD can be delayed until April 1 following the year the employee retires.