When the cynics among you hear the words “free gift,” you know that what you’re getting is neither. Those “free” refrigerator magnets, bonus miles or toasters are yours to keep only if you agree to put your money into something, right?
Well, your 401(k) or thrift retirement-savings plan is no different, except that the “free gift” in a 401(k) is called a “matching contribution.” The “match,” as it’s often called, is what your employer offers you if you agree to put money into your account.
The match can be quite enticing. A common scenario is that an employer will chip in 50 cents for every dollar you put into your 401(k), as much as 6 percent of your pay. So, someone making $50,000 who contributes 6 percent of pay ($3,000) to his 401(k) will get a matching contribution from his employer of $1,500.
Free money.
Or is it? Like any other free gift, the “matching contribution” isn’t always a freebie. Sometimes there are strings attached: You may get the employer’s contribution only if you agree to make riskier investments in your company’s stock instead of in safer mutual funds. You may keep the money only if you stick around for a number of years. And the guy sitting next to you might be getting a bigger matching contribution. (More on that below.) That said, the more you know about how your “match” works, and why you get it, the better off you’ll be.
Employers have a lot of reasons for matching contributions, many of which have nothing to do with helping everyone save for retirement. Matches aren’t made in heaven; they’re made in the treasurer’s offices–for sound financial reasons.
One of the most common reasons for offering a match is that it increases participation among the lower-paid, who are typically younger and less worried about retiring in 30 years than they are about paying next month’s rent.
But when too few clerks and support staff join the plan and put money in, it can hurt the higher-paid. The Labor Department has tests to ensure that 401(k) plans aren’t run as savings accounts only for the people at the top, so unless a certain percentage of the rank-and-file participate, the folks making more than $70,000 or so can find that they aren’t allowed to put in the maximum allowed by law, which is $10,000 this year.
So, employers have discovered that the best way to get the rank-and-file on board is to offer a match. This doesn’t cost employers too much, since the lower-paid are the least likely to ultimately collect the matching contribution. That’s because what few employees–of all income levels–realize is that their employer usually requires them to work a number of years before they’re “vested” in the employer’s match. Leave before five years in many cases, and you leave behind all that money. (You’re always 100 percent vested in your own contribution, however.)
That didn’t amaze an executive at Hertz Corp. who left after participating in the 401(k) for only 1 1/2 years (it takes five years to vest). “But what took me by surprise was that they also took the earnings on those contributions,” he says. He had invested the matching contribution in stock funds that returned 35 percent gains his ex-employer kept.
Forfeited contributions, plus earnings, can really add up, especially at companies with a lot of turnover.
“A company with high turnover can afford to be more generous with the match, since ultimately they won’t pay it all out,” says Steven Fuchs, an independent actuary in Glen Carbon, Ill. Employers use the forfeited matching contributions to make future contributions, which reduces their costs. He says that a 2 percent match will cost only 1 percent to 1.5 percent, because of forfeitures.
A Labor Department official says the fact that the higher-paid are the primary beneficiaries of matching contributions (thanks to high turnover, vesting requirements and loopholes) is an unintended consequence. “At least some of the low-paid will save, and will vest in their accounts,” he says. Employers aren’t required to offer 401(k)s, so they have a lot of leeway over how they use them. “You make a deal with the devil.”
But even the higher-paid employees have to watch out for pitfalls with matching contributions. Many employers offer a matching contribution only in company stock, which can leave employees dangerously underdiversifed. About a third of the money in two 401(k) plans offered by Cendant Corp., which owns a number of brands including Avis, Days Inn , Ramada, Coldwell Banker and Century 21, is invested in the company stock.
Some companies like Exxon Corp. and General Dynamics Corp. give a larger matching contribution only if you invest your own savings in company stock.
All the sourball talk aside, the company match is still incredibly valuable. Here are some things you should consider doing to get the most out of it:
It’s generally a good idea to contribute to your account, at least up to the matching contribution. Even with strings attached, the match is an invaluable way to increase your savings.
Once you contribute up to the percentage that will receive a match, put money into a Roth IRA (individual retirement account), if you’re eligible (you can contribute to a Roth even if you’re covered by an employer plan, as long as your joint income is $150,000 or less, or $95,000 if you’re single). Money comes out of a Roth tax-free, which beats a 401(k) contribution, which is fully taxable on withdrawal.
If you can afford to contribute above the match, go ahead. Your contributions lower your taxable income, something that is still valuable.
If the matching contribution is in employer stock, diversify your other holdings if you can. If that’s not possible (say, you’re allowed to invest only in company stock), contribute up to the match, and put $2,000 into a Roth IRA.
Find out what the vesting requirements are, and don’t quit your job till you find out what kind of hit you’d take. If you know you won’t be around to collect the match, consider putting money into a Roth IRA instead.
If you’re highly paid, spread your contributions over 12 months. You’re allowed to contribute as much as $10,000 (unless there are further company restrictions). But if you front-load all your contributions in the early part of the year (because you want to get the money fully invested), you might leave some employer match behind. How? If the employer provides a match on a monthly basis, and you contribute only during the first six months, you won’t get the employer match for the last six months. You could lose out on hundreds of dollars. Ask your employer if this could happen to you.
