About 401(k) plans

A 401(k) is a retirement savings plan that you set up on behalf of your employees. Participating workers can contribute to the plan by deferring part of their salary. These contributions are called elective deferrals. As the employer, you have the option to match part or all of your employees’ contributions to help them save more for retirement—this feature sets a 401(k) apart from individual retirement accounts (IRAs).

If you set up a traditional 401(k) plan, the IRS allows employees to deduct contribution amounts from the year’s taxable income, reducing their tax burden. The money grows tax-free, but employees pay income tax on withdrawals. If you choose a Roth 401(k) plan, employees pay taxes on contributions. However, qualified withdrawals are tax-free.

How does an employer 401(k) match work?

A 401(k) match happens when you contribute money to your employees’ retirement accounts. Depending on the terms of the plan, you might match part or all of their contributions.

If an employee defers $500 from each paycheck, and you offer a 100% match, you’d also contribute $500. If you offer a 50% match, you’d contribute $250.

Most 401(k) plans set limits for employer matching—you might offer to match contributions up to 6% of the employee’s salary, for example.

Contribution limits and rules for a 401(k) match

The IRS also limits the contributions you and your employees can make to 401(k) plans. Keep in mind that the specific amounts change each year to account for inflation.

• Employer contribution limits: Your 401(k) contributions are limited by three factors: the plan type, IRS annual limits and employee salary. Regardless of the plan, the total combined employer and employee contributions can’t exceed $61,000 in 2022 or the employee’s salary, whichever is less. If your 401(k) match is based on the employee’s salary, you can only calculate your contributions on the first $305,000 of their compensation.
• Employee contribution limits: In 2022, employees can make salary deferrals of up to $20,500 for a traditional 401(k) and $14,000 for a SIMPLE 401(k). Workers who are 50 or older can also make catch-up contributions of $6,500 per year or $3,000 for SIMPLE 401(k) plans.

The type of 401(k) plan you choose can also affect your contributions.

Traditional 401(k)

These plans offer the most flexibility, allowing you to match a part or all of an employee’s contributions. You can also make non-elective contributions—money you direct to each participating employee’s account, regardless of individual salary deferral amounts. IRS rules permit you to make one or both types of contributions in the same year.

A traditional 401(k) also enables you to create a vesting schedule that determines when employees are entitled to the employer matching funds. For example, you might vest employees at a rate of 25% per year. After 4 years, the employee would own 100% of the account. If an employee quits before they’re fully vested, you could take back a portion of your matching contributions.

It’s important to note that if you choose a traditional 401(k), the IRS will administer tests each year to make sure your matching contributions aren’t giving an unfair advantage to your top-earning employees.

SIMPLE 401(k)

A SIMPLE 401(k), gives you two options: you can match employee contributions up to 3% of their salary, or you can make non-elective contributions that total 2% of each participating employee’s salary.

Since these plans have low employee contribution limits, this can be an affordable option if you run a small business. Your maximum match amount would be $14,000 per person—and you’d only reach that level if an employee made $466,667 per year. For an employee making $100,000 per year, your maximum match amount would be $3,000.

Automatic enrollment 401(k)

This type of 401(k) plan gives you two ways to contribute to employees’ accounts. If you don’t want to match employee contributions, you can offer a flat non-elective contribution of 3% of each person’s salary. Alternatively, you must match 100% of employee contributions up to 1% of their salary; after that, you must match 50% of employee contributions. Your total match amounts can’t total more than 6% of the employee’s salary.

Safe harbor 401(k)

If you choose a safe harbor 401(k) plan, there are two tiers of contribution matching. First, you can match up to 100% of an employee’s contributions until you reach 3% of their salary. After that, you’re allowed to match up to 50% of the employee’s additional contributions until the total match amount reaches 5% of their salary.

Imagine that you have an employee making $100,000 per year. Contributions to their safe harbor 401(k) plan might look like this:

• Stage 1: The employee contributes $3,000; you match it dollar for dollar, contributing $3,000 (3% of their salary).
• Stage 2: The employee contributes an additional $4,000; you match 50 cents for every dollar, contributing $2,000. You’ve now matched $5,000, or 5% of the employee’s salary.
• Stage 3: The employee maxes out their contributions, deferring an additional $13,500. Since you’ve already hit the annual limit, this money is unmatched. At the end of the year, the employee’s account has $20,500 in salary deferrals and $6,000 in matched contributions for a total of $25,500.

The safe harbor 401(k) also allows you to make non-elective contributions instead of matching. If you choose that option, you must contribute 3% of each participating employee’s salary to their 401(k).

What is a good 401(k) match?

As you’re choosing a 401(k) provider and setting up a retirement plan for your employees, you’ll need to decide on a match percentage and limit. A good 401(k) match is high enough to keep employees happy but not so high that you can’t afford it. In the United States, the average match amount varies between 3% and 5% of employees’ salaries. Companies that offer partial matching often match 50% of contributions up to 6% of the total salary.

If you choose a traditional 410(k), you may also need to select a vesting schedule. Again, the right schedule strikes a balance between the needs of your company and your employees. On average, employees become fully vested in 3 years. Employee salary deferrals are fully vested immediately; the vesting schedule applies only to your contributions.

These are just averages—the standard in your industry or city may be higher. If your goal is to attract high-quality candidates, it’s important to offer a matching program that’s on par with the companies competing for the same employees.

What employees are eligible for a 401(k) match?

The IRS doesn’t set eligibility rules for 401(k) matching. However, you’re required to allow employees to participate in your 401(k) if they’re at least 21 years old and they’ve worked for your company for at least 1 year (or 2 years for a traditional 401(k) plan). Your matching program must be available to all participating employees.

Tax implications of 401(k) matching for employers

Employer matching is essentially free money for your employees—but how does 401(k) work match benefit employers? Your matching contributions create a tempting benefits package, but they also have positive implications when it’s time to file your business taxes.

When you match employee contributions, you can deduct the amount from your company’s income tax. That includes the amounts the company contributes to your own retirement plan.

You can deduct up to 25% of the salaries you pay to the employees who participate in the 401(k). If your participating workers earn $500,000, you can claim tax deductions for up to $125,000 worth of matching contributions.

When you’re calculating the total compensation, the IRS allows you to include up to $305,000 per employee. That means if one employee makes $500,000, you can only consider $305,000 of it in the deduction calculation.

Carryover deductions

What happens if your contributions exceed the deduction limit? The IRS allows you to carry over the excess amount to another year and take it as a deduction. Keep in mind that your total annual deductions must still fall within the 25% limit.

Carryover rules come in handy if your matching contributions vary from year to year. Let’s say your match amount is $200,000 one year, but your maximum deduction is $150,000. The next year, employee contributions drop, and you match $100,000. If your maximum deduction is still $150,000, you can carry over the remaining $50,000 from the previous year and take it as a deduction.