Offering a 401(k) matching program as part of your employee retirement plan can be a helpful incentive for attracting top employees to your business.
- 401(k) employer matching is the process through which an employer matches an employee's contributions to their retirement account.
- 401(k) employer matches can improve employee morale and retention, attract better new hires to your company and provide your company tax benefits.
- When offering 401(k) matching, you should set employer match contribution limits, review the IRS' contribution limits and include vesting provisions.
- This article is for employers that are looking to set up a 401(k) employer match program.
Retirement plans are among the benefits that employers most commonly offer their employees. Some employers take their retirement offerings a step further by offering 401(k) employer matching, which incentivizes employees to participate by adding money into their retirement savings based on how much they are contributing each pay period.
If you're thinking about opening retirement accounts for your team or just want to improve your existing 401(k) options, you may want to consider setting up a 401(k) employer match as well. Before doing so, though, you should have a clear understanding of what 401(k) employer matching is, what the benefits are and how you should operate your 401(k) matching program.
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What is 401(k) employer matching?
401(k) employer matching is the process by which an employer contributes to an employee's retirement account based on the employee's contributions. Employers tend to set their 401(k) contribution limits based on the employee's annual salary. In other words, an employer's contribution rate may be at most a certain percentage of the employee's salary. For example, an employer may be willing to match 50% of an employee's contribution, up to 6% of their annual salary. So, if the employee contributed 6% to their 401(k) plan, the employer would contribute an additional 3% to the employee's retirement savings.
Rarely, some employers instead set a contribution limit of a predetermined dollar amount that's unrelated to the employee's annual salary.
Key takeaway: 401(k) employer matching is when an employer also contributes to an employee's retirement account.
Why should you offer a 401(k) employer match?
Offering a 401(k) employer match as part of your employee retirement plan has three primary benefits for your company:
- Better recruiting. Not all companies offer a 401(k) employer match, so doing so can help your business stand out to top job candidates. Offering better benefits correlates with hiring better candidates.
- Stronger employee morale and retention. Just as offering 401(k) contribution matching can draw better recruits to your business, this benefit can also improve employee morale and retention at your company.
- Employer tax benefits. There are tax savings that businesses can take advantage of by offering 401(k) employer matching. Tax laws allow employers to claim their matching contributions as tax deductions.
Key takeaway: Offering a 401(k) employer match program can attract stronger new hires, reduce taxable business income, and boost employee morale and retention.
Is offering a 401(k) employer match mandatory?
Although offering a 401(k) employer match for your employees' retirement plans may benefit your business, there are no laws requiring employer matching. However, if you do offer a 401(k) employer match contribution program, you are legally required to conduct nondiscrimination testing to ensure your program equally benefits all of your employees. These IRS-created tests, known as the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests, ensure that your company's most highly paid employees benefit as much from tax-deferred contributions as your other employees.
Key takeaway: Employers are not required to offer a 401(k) employee match, but those that do must regularly test for compliance with nondiscrimination standards that ensure employees of all incomes benefit equally from tax-deferred contributions.
How does 401(k) matching work?
When you're setting up a 401(k) matching program, consider the answers to these three questions:
How much should you match 401(k) contributions?
Employers' 401(k) match amounts vary widely. However, all contribution limits and withdrawal regulations must comply with the standards of the Employee Retirement Income Security Act. Otherwise, you can set your 401(k) contribution rates however you please.
There are two especially common methods for determining how much money you should contribute to your employees' retirement accounts:
- Percentage of an employee's wages. Some employers will match all employee contributions up to a contribution limit equal to a percentage of an employee's wages. For example, if you set a contribution limit of 4% of an employee's income and the employee makes $50,000 per year, you will contribute at most 0.04 x $50,000 = $2,000 over the course of the plan year. Note that if your employee contributes less than $2,000 to their retirement account, you have to match only that amount, not the full $2,000.
- Percentage of an employee's contributions. Other employers will match a percentage of contributions instead. For example, if you choose to match 40% of your employees' contributions with the same 4% contribution limit as in the prior example, then for an employee with a $50,000 annual salary, your employer contribution limit isn't $2,000 over the course of the plan year. Instead, it's 0.4 x $2,000 = $800.
What is the maximum amount you can contribute to 401(k) plans?
When determining how much money you should contribute to an employee's retirement account, you should also consider the annual contribution limits that the IRS sets for both yourself and your employee. For 2020, the limit on elective salary deferrals – retirement plan contributions an employee voluntarily makes – is $19,500 for a traditional 401(k) plan. For a SIMPLE 401(k) plan, this limit is lowered to $13,500. Employees age 50 and older can contribute an additional $6,500 in elective salary deferrals to a traditional 401(k) plan or $3,000 to a SIMPLE 401(k) plan.
The total contribution limit a person can make to an employer-sponsored retirement account during a year is the sum of elective salary deferrals, employer contributions and allocations of forfeitures. For 2020, the total contribution limit is $57,000, or for an employee with an annual income below $57,000, the limit is whatever their income is. Notably, if an employee has a retirement account with your company and a separate 401(k) they contribute to through side income they generate as an independent contractor, that separate account is unaffected by the limits on your employer-sponsored account.
How does 401(k) vesting relate to 401(k) matching?
As an employer, you can take ownership of part or all of your employer match contributions through a practice known as vesting. The legal definition of vesting is the right to ownership over a future payment, benefit or asset. When applied to retirement accounts, vesting describes the process of employees earning greater rights to access their employer contributions as time passes. That's why the vesting schedule you set for your 401(k) employer match is a crucial component of your program.
Your vesting schedule can incentivize your employees to stay with your company longer, because the longer your employees stay with you, the more their nonforfeitable rights to your employer contributions grow. After a set number of years, your employee can leave your company while taking all of your employer matching contributions with them, but employees who leave too soon may forfeit some or all of your employer matching contributions.
Key takeaway: To figure out how your 401(k) matching process will work, determine your employer match contribution limits, familiarize yourself with the IRS-mandated 401(k) contribution limits and determine a vesting schedule that drives employee retention while minimizing your financial risk.