This is the second post in a series of posts that explain the mechanics of a 401(k) plan. As mentioned previously, there are many types of Qualified Retirement Plans (collectively called QRPs) that share common characteristics. Some of these plans are called 401(k), 403(b), and 457. In these articles we’ll simply refer to 401(k) plans to address common characteristics of all of these QRPs.
Many companies provide a matching contribution to the 401(k) plan – and sometimes there is a contribution made to a QRP on your behalf no matter if you have contributed your own deferred salary or not.
Most of the time these matching contributions are stated as x% of the first y% of contributions to the account. An example would be “50% of the first 6%”, meaning if you contribute 6% of your salary to the plan, the company will match that contribution with 3% (50% of your contribution). This matching rate is up to the company, but it must be applied without discrimination for all employee-participants in the plan.
Sometimes the company designates that your contribution must be invested solely in company stock – this is less common these days, but it still occurs. Otherwise, once you’re vested in the plan, this matching contribution is your money. (We’ll cover vesting later.)
As mentioned previously, most often employer contributions are in the form of matching contributions – dependent upon employee-participants’ making deferrals into the program in order for the company to make a contribution to your account.
In a 50% of the first 6% match plan (as an example), if your salary is $30,000 and you defer 5% or $1,500 into the plan, your employer would match that with a $750 contribution. As mentioned in the earlier post on saving/contributing to your 401(k) plan, this deferral could result in a tax savings of approximately $225 in these circumstances.
When you balance it out, you wind up with $2,250 in your 401(k) account and a tax bill that’s $225 lower.
In some cases, the employer makes contributions to your 401(k) plan regardless of whether you defer salary into the plan. In these cases, called Safe Harbor plans, the employer wants to ensure that there are contributions made on behalf of all employees (to encourage saving and participation) and to ensure that there is no discrimination toward higher-salaried employees. If there were discrimination in favor of higher salaried employees the plan itself could become disqualified by the IRS and all tax benefits would be eliminated.