A 401(k) plan is a popular retirement savings option offered by many employers in the U.S. It allows employees to contribute a portion of their pre-tax income to a designated account, where it can grow tax-deferred until withdrawal. Some employers also offer to match some or all of the employee contributions, as an incentive to encourage saving for retirement. But how are these employer matches treated for tax purposes? Are they deductible or non-deductible contributions?
The answer depends on whether the employee contributes to a traditional 401(k) or a Roth 401(k). A traditional 401(k) is funded with pre-tax dollars, which means that the contributions reduce the employee’s taxable income for the year. A Roth 401(k) is funded with after-tax dollars, which means that the contributions do not affect the employee’s taxable income for the year, but the withdrawals are tax-free in retirement.
Regardless of the type of 401(k) plan, the employer matches are always made with pre-tax dollars and are always considered non-deductible contributions. This means that the employer matches do not reduce the employer’s taxable income for the year, but they also do not increase the employee’s taxable income for the year. However, the employer matches are subject to taxation when they are withdrawn from the account, along with the earnings they generate.
To illustrate this, let’s look at an example of an employee who contributes $10,000 to a traditional 401(k) and receives a 50% match from the employer, resulting in a total contribution of $15,000 for the year. Assuming a 22% marginal tax rate, the employee’s taxable income for the year is reduced by $10,000, saving them $2,200 in taxes. The employer’s taxable income for the year is not affected by the match, but they incur a $5,000 expense for the match. The table below summarizes the tax implications of this scenario.
| Contribution | Taxable Income | Tax Savings | Tax Expense |
|---|---|---|---|
| Employee | -$10,000 | +$2,200 | -$2,200 |
| Employer | $0 | $0 | -$5,000 |
| Total | -$10,000 | +$2,200 | -$7,200 |
Now, let’s assume that the employee withdraws the entire $15,000 from the account after 10 years, when it has grown to $25,000, due to a 5% annual return. Assuming the same 22% marginal tax rate, the employee will have to pay $5,500 in taxes on the withdrawal, which includes both the original contributions and the earnings. The employer will not have to pay any taxes on the withdrawal, as they have already paid them when they made the match. The table below summarizes the tax implications of this scenario.
| Withdrawal | Taxable Income | Tax Savings | Tax Expense |
|---|---|---|---|
| Employee | +$25,000 | -$5,500 | +$5,500 |
| Employer | $0 | $0 | $0 |
| Total | +$25,000 | -$5,500 | +$5,500 |
As you can see, the employer match in a traditional 401(k) is a non-deductible contribution that does not affect the taxable income of either the employee or the employer in the year of contribution, but it is taxed as ordinary income when it is withdrawn from the account, along with the earnings it generates.
The same logic applies to a Roth 401(k), except that the employee’s contribution is made with after-tax dollars and is not deductible. Therefore, the employee’s taxable income for the year is not reduced by the contribution, but the withdrawal is tax-free in retirement. The employer’s match, however, is still made with pre-tax dollars and is still non-deductible. Therefore, the employer’s match is taxed as ordinary income when it is withdrawn from the account, along with the earnings it generates.
According to the IRS, contributions to all accounts (elective deferrals, employee contributions, employer matching and discretionary contributions and allocations of forfeitures) may not exceed the lesser of 100% of employee compensation or $61,000 for 2024 ($76,500 including catch-up contributions). For 2023, employees can contribute up to $22,500 to 401(k) accounts, with an additional catch-up contribution of $7,500 allowed for those aged 50 and over.
Not taking advantage of an employer match is the equivalent of leaving free money on the table. However, employees should also be aware of the tax implications of the employer match and plan accordingly for their retirement income. A financial advisor can help employees choose the best type of 401(k) plan for their situation and optimize their tax savings.
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