Front Loading 401k Too Early Could Cost Your Employer Match
The key to a secure financial independence often lies in planning and maximizing your available opportunities. A 401(k) retirement savings plan is one of the retirement accounts that many utilize for their retirement plan. It’s a common strategy to max out and front load your 401(k) as early as possible each year. This is to take advantage of the time value of money. While there are several benefits to this, it’s essential to understand one potential downside as it may result in losing out on some of your employer’s match.
The practice of the front-loading strategy or maximizing your 401(k) contributions in the first part of the year has several advantages. It can potentially give your money more time in the market and make the most of any bullish trends that might occur early in the year. However, if your employer matches your contributions, you may be leaving money on the table by missing out on the full match.
Understanding Employer Matching
In a 401k plan, both the employee and employer can contribute. As of my knowledge cutoff in July 2023, this year’s annual contribution limit is $22,500 (under 50). For those 50+, an additional “catch-up” contribution of $7,500 is allowed, totaling $30,000. Employers also commonly offer to match a percentage of the employee’s contribution, typically up to a certain percentage of the employee’s salary.
For example, your employer might offer a 100% match on the first 5% of your salary that you contribute to the 401(k). So, if your salary is $100,000 and you contribute 5% ($5,000), your employer would also contribute an additional $5,000.
Font loading 401k Issue
Suppose you decide to front load your contributions early in the year. This might sound like a good idea, especially when you consider compound interest. However, the problem arises with how employers calculate and deposit their matching contributions.
Most employer contributions apply their match on a paycheck-by-paycheck basis through-out the contribution year. So, if you hit your contribution limit before the year ends, your contributions for the remaining pay periods drop to $0. Since most employers only match when you contribute, once you stop contributing, your employer stops matching. Therefore, maxing out your 401(k) early can cost you part of the employer’s match.
For instance, if you make a $120,000 annual salary and max out your contributions in June, you miss out on the employer’s match for the rest of the year. If your employer matches 100% of your contributions up to 5% of your salary, you could potentially lose out on $3,000 ($120,000 * 5% / 2). That is an11.7% percent increase. If you have a front-loaded account the full year total is $25,500 compared to a $28,500 total. This applies if you are below 50. If above 50, it would be a $33,000 total for the early max out plan ($22,500+$7,500) and $36,000 total but still an 8.3% increase ($22,500+$7,500+$6000).
Front Loading 401k Solution
The good news is the solution is easy. Simply pace your contributions throughout the end of the year. This will ensure that you’re contributing (and receiving your employer contribution) in each pay period. This strategy is known as “dollar cost averaging”. Dollar cost average involves making regular, equal contributions that spread out your investment over time. This simple solution will ensure you earn the maximum employer match.
Not only does this help you capture the full employer match, but it also offers other benefits. By investing smaller amounts regularly, you reduce the risk of investing a large amount just before a stock market downturn.
Quick Reference Sheet
Wrap Up
While some say to front load your 401(k) contributions early as a good investment strategy, remember to consider your company match process. This is essentially free money that can significantly boost your retirement savings in the long run. The best way to ensure this does not happen is to portion of the employer match is contributed every pay period throughout the entire year. Bottom line is you want hit the max at the last pay period.
Before making any drastic changes, it’s always a good idea to speak with your company’s HR or payroll department to understand how they calculate and apply the employer match.
In retirement planning and especially in early retirement, every dollar counts therefore it’s important to maximize all opportunities to grow your savings and secure your future.
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