What it means
The name comes from the section of the tax code that created it. An employee chooses a percentage of pay to contribute, the payroll department sends that amount to the plan each pay period, and the employee picks from a menu of investment funds.
There are two main tax versions. With a traditional 401(k), contributions come out of pay before income tax, which lowers the tax bill today, and withdrawals are taxed in retirement.
With a Roth 401(k), contributions are made from pay that has already been taxed, and qualified withdrawals later are tax-free. The employer match is the feature that makes the plan especially valuable.
A typical formula is that the employer adds 50 cents for every dollar the employee contributes up to a set percentage of pay, which is an immediate return on the employee's saving. Limits apply.
The tax authority sets the maximum yearly contribution and revises it from time to time, and withdrawals before the standard retirement age usually face an extra penalty tax on top of ordinary tax. Some plans also allow loans, though these reduce the savings working for the future.
Vesting is another important rule. Money the employee contributes is always theirs, but the employer's matching money may belong to them only after a set period of service, so leaving a job early can mean losing part of it.
For employers, offering a plan is a way to attract staff and manage the cost of benefits. It also brings duties, including choosing fair investment options, keeping fees reasonable and passing the testing rules that stop a plan favouring highly paid staff.
In practice
Real-world examples
Example 1
A 35-year-old marketing manager earns $90,000 and contributes enough to receive the full employer match. She chooses a low-cost target-date fund (a fund that gradually becomes more cautious as retirement approaches). Over time the matched money does a good share of the work of building her retirement pot.
Example 2
The founder of a 40-person company sets up a 401(k) to compete with larger firms for engineers. The plan adds administration fees of a few thousand dollars a year, but the owner finds that candidates ask about it during interviews. The company also receives a tax deduction for its own contributions.
Example 3
A sales director changes jobs after three years, with a vested balance of $60,000. He rolls the money into an individual retirement account at his new provider, so that the balance continues to grow tax-deferred. He checks that the transfer goes directly between institutions, which avoids a tax charge.
Think of it
401(k) is a retirement account through your employer-tax-advantaged savings.
Formula
Calculation
Total yearly contribution = Employee contribution + Employer match
Employer match = Match rate x lower of (employee contribution, matching cap % x salary)
Suppose an employee earns $80,000 and contributes 6% of pay, which is 80,000 x 0.06 = $4,800. The employer matches 50% of contributions up to 6% of pay, so the match = 0.50 x 4,800 = $2,400. Total yearly contribution = 4,800 + 2,400 = $7,200, so the employer's match adds an immediate 50% to the employee's own saving.Case study
Seen in the real world
Brightwater Foods is an illustrative, fictional company with 120 employees and a 401(k) that offered no match. Only 38% of staff were contributing, and several managers complained that the benefits package looked weak compared with competitors.
The finance director proposed a match of 50% of contributions up to 6% of pay. She estimated that if participation rose to 75% of staff (90 people) with average pay of $78,000, the annual cost would be about 90 x 0.50 x 0.06 x 78,000 = $210,600, which she compared with the cost of recruiting and training replacements for staff who left.
After the match was introduced, participation climbed to 78% within a year, and staff turnover fell. The illustrative lesson is that a match is a cost, but it can pay for itself through better retention and a more committed workforce.
Watch out
Common mistakes
- Contributing less than the amount needed to receive the full employer match, which leaves free money unclaimed.
- Leaving the whole balance in cash after joining, when the money is not invested and cannot grow.
- Withdrawing the balance when changing jobs, which can trigger tax and a penalty that a transfer to another retirement account avoids.
Questions
People also ask
What is the difference between a traditional and a Roth 401(k)?
A traditional plan gives a tax deduction now and taxes the withdrawals later, whereas a Roth plan taxes the contributions now and allows qualified withdrawals tax-free.
Is the employer match guaranteed?
No, it depends on the employer's plan rules, which may change, and the match may also be subject to a vesting schedule.
What happens to a 401(k) when I leave my employer?
You can usually leave it in the old plan, move it to a new employer's plan, or roll it into an individual retirement account.
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