Just to rehash from last time, if your company offers you a 401(k)/403(b), you should take advantage if the company is matching your contribution. If your company does not match any percentage of your contribution, then you should open an IRA with the lowest expense rations (aka click here). Matching Contributions work as follows.
Saving Money from Being Taxed
Based on what I explained earlier, you are taxed on all income you do not contribute to your pre-tax retirement, and you can max contribute up to $17,500. If you make, $50,000 a year and your company pays you in the middle and end of every month, it means that your company is paying you $50,000 in 24 separate installments (2 for every month) which comes out to $2,083.83. If you contributed $17,500 to your pre-tax retirement account, you would only be taxed on earning $32,500 as income. This can put you in a completely separate tax bracket for both state and federal taxes.
In 2013, singles making between $8,925 and $36,250 paid a 15% federal income tax, while those making between $36,251 and $87,850 paid 25%. If we use our example, the person making $50,000 would have paid a 25% federal income tax on his salary and handed over $12,500 to the federal government. However, if they manage to save 30% ($15,000) of their salary in their pre-tax retirement account, then the IRS would only be able to tax their personal income at 15% because they were only making $35,000 a year. 15% of $35,000 comes out to $5,250. In our very simple example, not only are you saving more than $7,000 from being taxed, but you are also investing $15,000 toward your retirement.
Taking Advantage of Matching Contributions
Getting back on topic here, most companies offer their employees incentives to stay and work for them. Part of those incentives include 401(k) matching contributions. The way they work is a company will match up to a certain percentage of how much you invest in your 401(k). Back to our example, if this person making $50,000 a year invest $15,000 into his 401(k) for tax purposes, he would need to contribute to this pre-tax account each paycheck.
We discussed earlier that they were earning $2,083.83 per paycheck. This means that if you were to calculate how much of a percentage per paycheck to contribute, you would take your contribution amount and divide it by the number of paychecks you receive a year. In this situation, it would be $15,000/24 or $625. You would then take this amount and divide it by your paycheck total. ($625/$2,083.83 =~ 30%).
Bottom line: If you want to save 15,000 in your pre-retirement account you need contribute 30% of each paycheck.
Your employer will generally match up to a certain % of your contribution to your pre-retirement account. My employers in the past have offered matches of 8%. This means that if I would contribute $625 my employer would have added an additional 8% of $2,083.83 or $166.64. If this was the case, then I would be saving an additional $1999.68 which would bring my total to just under $17,000.
Matching Contribution Issue
Matching contributions are important for this very reason. If my employer offered a 12% in our example, this would put me at saving >$17,500 a year. If that’s the case, then once I crossed the limit, I would be ineligible to contribute to the retirement account for that fiscal year and would lose free money my company is offering me. How do I figure?
Using our example, with a 12% matching contribution, my employer would be matching me ~250. This would mean that after 10 months, I would have reached $625*20 + 250*20 = $15,000. I would be able to save $625 * 4 for the last remaining paychecks, but the matching contribution would stop kicking in by my last paycheck because I would be over the limit.
It’s important to keep this in mind when you prepare for the year. The last thing you ever want to do is turn down free money from your employer.
If you have any questions, comment and I will answer.