If your job offers a 401(k) plan as part of its benefits package, your employer may offer to match your contributions up to a certain percentage of your salary. This 401(k) match can boost your retirement income by thousands of dollars, and you won't have to pay any extra income taxes this year.
How does 401(k) matching work?
Many employers choose to match employees' contributions to their 401(k) accounts in order to incentivize retirement saving. While the money employers contribute can't be used until retirement, this can be thousands of dollars per year, and should be taken advantage of, if offered.
Ninety-one percent of Vanguard's retirement plans offer an employer match of some kind, but the way companies structure their matching contributions varies widely. In general, the match is defined as a certain percent of contributions, up to a certain percent of the employee's salary. For example, an employer contribution of "50% of employees' contributions, up to 6% of salary" means that the employer will contribute half of what its employees do, with a maximum employer contribution of 3% of the employee's salary.
Some employers impose a waiting period before employees are eligible for matching contributions, while others require a number of years of service before employees are "vested" in the employer contributions in their accounts. Another common structure is a service-based matching formula, giving more favorable matching percentages to employers who have been there for longer.
The long-term impact of 401(k) matching
To illustrate just how much of an impact 401(k) matching can have, let's consider an example. Let's say that you earn a salary of $50,000 per year and that your employer is willing to match all of your 401(k) contributions, up to a maximum of 6% of your salary.
Without the matching contributions, this means that you're contributing $3,000 per year into your 401(k). Assuming 2% annual raises and 7% average investment returns, this could result in a $520,000 nest egg after 35 years.
However, with the matching contribution, this doubles your investments and would result in a nest egg of more than $1 million. This can make a big difference in your post-retirement quality of life.
Tax implications and withdrawal rules
I mentioned in the introduction that 401(k) matching contributions won't result in any additional income tax liability this year. This is because 401(k) plans are tax-deferred, meaning you won't pay income tax on the money you contribute, but your eventual withdrawals will be treated as taxable income.
Just like the rest of your 401(k) contributions, you can withdraw your matching contributions penalty-free as soon as you're fully vested in your plan, and you're 59 1/2 years of age or older. There are a few exceptions to this age requirement, and you can read about them here.
One of the best employee benefits
A 401(k) matching program ranks right up there with health insurance as one of the best benefits your employer can offer. Not only is a 401(k) match effectively tax-free income, but the long-term effects can be incredible. For this reason, it's important to take full advantage of your employer's 401(k) match – if you're contributing anything less than the percentage your employer is willing to match, you are literally turning down free money.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org . Thanks -- and Fool on!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.