The 411 on 401(k) Matches

For this week's Short Answer we're breaking from our usual format to answer a series of questions. Think of it as "The Even Shorter Answers."

Does my company's matching contribution to my 401(k) count toward my annual contribution limit?
Yes and no. Strictly speaking, the company's matching contribution does not count against your own employee annual contribution limit, which currently stands at $17,500 ($23,000 if you are age 50 or older). So you can contribute up to that amount, and whatever your employer matches is irrelevant. If you participate in more than one 401(k) plan, the limit applies to your total contributions to all plans.

However, there is another contribution limit that pertains to both employee and employer 401(k) contributions. Total contributions combined cannot exceed $51,000 per year ($56,500 for older workers). Although this amount may seem out of reach for most workers, it can come into play if a company's match is generous enough or if the plan includes a profit-sharing component.

To maximize company contributions, you'll want to save at least enough to get the full employer match, but you might also need to pace your contributions so you don't hit your own $17,500 cap too early in the year and miss out on company matches in the later months. See this Short Answer column for more details on maximizing your match.

If I am contributing to a Roth 401(k), why do my employer's matching contributions go into a traditional 401(k)?  
It may seem a little frustrating for workers who sign up for the Roth 401(k) option to find that their employer doesn't match their contributions in kind--in other words, by adding the match to the Roth 401(k). But by law this is not allowed.

To understand why, consider the key distinction between traditional and Roth 401(k) plans. In a traditional 401(k), employee contributions are made on a pretax basis, with any employer match (also pretax) added to the account. Later, when the employee takes distributions (or withdrawals if prior to age 59 1/2) he pays income tax on the money. With a Roth 401(k), employee contributions are made on a posttax basis. Then, when distributions are made (once the employee is at least 59 1/2), they are tax-free. If your employer were to add its matching contribution to your Roth 401(k), it would be putting pretax dollars into an aftertax account. That means no taxes would ever be paid on the money, and the government tends to frown upon this. Therefore company-matching contributions to Roth 401(k) accounts must be made to traditional 401(k) accounts.

How can I tell if my company match is competitive? 
Figuring out how your employer's 401(k) match compares, say, with the one your friend gets from his employer may well require some basic math. Let's say your friend's employer matches $0.50 on the dollar for employee contributions up to 7% of pay, while your employer matches dollar-for-dollar on employee contributions up to 3% of pay. On the surface your friend's plan would seem to be more generous; if your friend contributes at least 7% of his salary, he gets a match equal to 3.5% of his salary, whereas you would get just 3%. However, the story changes if your friend contributes less than 7% of his salary. For example, if he only contributes 5% of pay, the actual amount of the match falls to just 2.5% of his salary, and your plan looks better by comparison. The point is that whether the company match is decent depends in part on the kind of saver you are. If you can afford to divert only a small portion of your salary to your 401(k), you may fare better if the employer matches dollar-for-dollar. 

Most 401(k) plans offer employer matches that are roughly in the same ballpark. In fact, nearly half of all employers participating in a 2011 survey by the Plan Sponsor Council of America reported matching employee contributions at $0.50 on the dollar, with the most common maximum match at 6% of pay (this combination accounted for 27% of all plans in the survey). Another 28% of plans match contributions dollar-for-dollar, while 14% match $0.25 on the dollar. Across all plans, the average matching amount was $0.63 on the dollar, and the average maximum percentage of pay matched was 5.2%. More than 800 plans participated in the survey, representing 10.3 million participants.

Ultimately, the size of the company match is an important part of assessing the quality of a 401(k) plan, but it's hardly the only consideration. Plan fees and rules, along with investment choices, also play key roles. Even if your plan is lacking in those areas, it's still probably worth contributing at least enough to get the company match, but after that an IRA may be a better choice for additional retirement savings.

Have a personal finance question you'd like answered? Send it to TheShortAnswer@morningstar.com.