How Does a 401(k) Benefit Employers and Employees?

Fact checked by Suzanne KvilhaugReviewed by Marguerita ChengFact checked by Suzanne KvilhaugReviewed by Marguerita Cheng

A traditional (non-Roth) 401(k) is a type of qualified retirement plan offered by many employers that allows an employee to deposit pretax dollars from each paycheck into a retirement account.

An employer can match an employee’s contributions in a number of different ways, such as contributing $0.50 for every $1 an employee contributes, up to a certain percentage of the employee’s compensation (such as 6%), or 100% of what an employee contributes, up to a certain percentage of the employee’s compensation (such as 4%).

In addition to varying contributions, different companies often have different vesting schedules. Some companies allow employees to retain full ownership of employer contributions the day they are hired, while other companies require an employee to be on staff for a specific period of time before retaining ownership of employer contributions. (Employees always own their own contributions to the plan.) Should the employee leave the company, the employee will own their contributions but not be entitled to the company’s match for any vesting period they did not achieve.

When the employee leaves the company, they can choose to rollover the 401(k) into a different plan, such as the 401(k) at their new company or an individual retirement account (IRA). If the employee withdrew the funds and didn’t perform a direct rollover or an indirect rollover, they would be subject to taxes on the amount and a 10% early withdrawal penalty unless they are 59 ½ or older.

If the employee maintains the account, the contributions and investment growth can be withdrawn in retirement to provide income and/or supplement Social Security benefits.

Key Takeaways

• Employers receive tax benefits for contributing to 401(k) accounts.
• A 401(k) puts the onus of contributing and investing for the future on the employee, not on the employer, as a pension does.
• Having a retirement plan helps attract and keep talented employees.

Benefits for Employees

Employers offer benefit programs to help employees feel valued and build financial security for themselves and their families through tax-advantaged savings.

Traditional (non-Roth) elective deferrals and investment gains are not taxed when the contribution is made. They enjoy tax deferral until their distribution. (Roth deferrals, however, are included in the employee’s taxable income in the year of the deferral).

With a defined-contribution plan like a 401(k), employees can grow their savings in a tax-deferred account and multiply their savings by way of the employer’s matched dollars. Matches vary. For example, the company’s contribution might be tiered. It might include 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 the employee’s compensation.

If you have a matching plan as a part of your employee benefits package, it is typically wise to make the most of it. It can be an important tool for building wealth and financial independence for your retirement years.

Benefits for Employers

Employers offer retirement savings plans to attract and retain a qualified workforce. Moreover, as more companies offer this type of plan as a standard benefit, those without it can be seen as lacking.

These days, most private-sector employers prefer defined-contribution plans like the 401(k) over a traditional pension. A pension plan guarantees a monthly payment for life. The amount is based on the employee’s tenure and salary history. Aside from the obvious financial burden, a pension requires employers to manage a retirement investing and payment system.

In contrast, 401(k)s and other defined-contribution plans put the onus of contributing and investing on the employee. These plans don’t guarantee a set payout at retirement, as pensions (also known as defined-benefit plans) do. Ultimately, this ends up being far more cost-effective for the employer.

The Internal Revenue Service (IRS) doesn’t make employer matches mandatory, but many employers do match employees’ contributions, up to a certain point. While it can be 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.

The company match can also entice employees to participate in the plan. This is necessary for the employer, because a certain percentage of a firm’s employees must participate for a plan to be considered legitimate by the IRS.

Employers can also deduct matched contributions from their income taxes, subject to certain limitations.

Some employers are required to maintain retirement accounts as part of state legislation. Several states have passed laws that require companies of a certain size to offer retirement plans to their employees or sign up for a private state-run program. For example, the Illinois Secure Choice Savings Program Act states that companies with at least five employees offer their own retirement program or facilitate a Illinois Secure Choice option.

Important

10 states have enacted laws requiring employers with more than a certain number of employees to offer a qualified retirement plan.

How Much Can an Employer Match in a 401(k) Plan?

For 2024, the most an employee under age 50 can contribute to a 401(k) is $23,000. An employer can contribute up to $46,000 (for a maximum total contribution of $69,000 per year). Employees over age 50 can make up to $7,500 in catch-up contributions that, along with employer matches, cannot exceed a total of $76,500 for 2024. And the total cannot exceed the employee’s compensation.

Do Most Employers With 401(k) Plans Offer Matching Contributions?

A 2024 survey reported that 96% of Vanguard plans had an employer contribution. Half (50%) had an employer match only, 10% had a non-matching contribution only, and 36% had both an employer match and an employer non-matching contribution.

What Is the Typical Size of an Employer Match in a 401(k)?

A study found that the average employer match for a 401(k) in 2024 was 4.6%. The median employer match is 4.0% of an employee’s pay. (“Median” is the middle-of-the-road number: half of matches are higher than this, and half are lower.)

The Bottom Line

Offering a retirement plan can benefit an employer. For one thing, 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.

The employer match is also an attractive employee benefit that can boost recruitment. If a candidate has offers from more than one company and all else is equal, the 401(k) employer match could help the potential hire choose one firm over another.

Read the original article on Investopedia.