Too Fast to Match? This 401(k) Misstep Could Hurt Retirement Savings
Sometimes, the early bird loses the worm … at least, when it comes to 401(k) savings.
Workers with cash to spare may be tempted to front-load their 401(k) retirement account contributions, maxing out their tax-advantaged contributions before the year's end. (For 2016, the IRS limit for tax-advantaged 401(k) contributions is $18,000, and $24,000 for those 50 or older.) This may result in more of your pay making it to your checking account for the year's remaining pay periods, which could come in handy around vacation time or the holidays.
But if your employer offers matching contributions, beware: maxing out your 401(k) early could mean you lose out on a portion of your employer's match.
Here's how it could happen, in a nutshell: Suppose your employer's 401(k) program provides a certain percentage match to each employee contribution per pay period. If you max out your 401(k) contributions early in the year and subsequently stop making contributions, your employer will also stop making matches, assuming the employer's plan does not provide for "true up" contributions. (More on true ups later.)
Let’s assume that an employer will match 50 percent of an employee’s contribution per pay period, up to 6 percent of employee compensation. A worker earning $75,000 would be paid $3,125 twice a month. To contribute enough money to reach the IRS's $18,000 contribution limit, she would need to contribute $750 per pay period, or 24 percent of her salary. In that scenario, the employer would contribute $93.75 in matching funds per pay period, since 6 percent of the employee’s pay would be $187.50, and $93.75 is half of that.
If, however, the worker decided to contribute $818.18 per pay period instead, she would max out her 401(k) contributions before the end of the year—by the 22nd pay period of the year, to be exact. For the two remaining pay periods of the year, her contribution would be $0— and her employer's matching contribution would be $0 as well because there would be nothing to match. That would mean she missed out on an extra $187.50 in contributions.
"Whether she had decided to contribute $750 or the $818.18 per pay period, she would have ended up contributing the same $18,000 total during the year to the retirement plan," said Anne St. Martin, a manager at the Society for Human Resource Management's Knowledge Center. "But if she had contributed $818.18 per pay period, she would have missed out on getting the employer match for each of the last two pay periods of the year."
That $187.50 in matching funds might not seem like much, but it can add up over the years—particularly when you factor in the returns you are missing on that money. And the consequences of 401(k) front-loading could be larger for high earners who max out just months into a new year or employees who decide to max out their contribution with a bonus awarded in the first months of the year, precluding them from several months' of employer matches.
You might be in luck, however, because some 401(k) plans include a feature that allows workers to get the maximum employer match even if they've finished contributing to their 401(k) plans early in the year. The feature, called a true up, allows employees to receive employer matches that they would have otherwise missed out on because of 401(k) front-loading or because they spread their 401(k) contributions out unevenly throughout the year.
In the example used above, had the worker's 401(k) plan included a true up feature, she would have received $187.50 in employer matching funds at the end of the year in addition to the matching funds she received during the pay periods when she did contribute to her 401(k). Of nearly 400 companies surveyed, 45 percent offered 401(k) true ups, according to a 2015 report on defined contribution plans.
Alternatively, your employer may calculate and make matching contributions on an annual basis. According to the 2015 survey, 12 percent of employers provide annual matching contributions.
There is at least one case when front-loading 401(k) contributions may make sense, even when it means losing out on some employer matching funds: when you're planning on leaving your company, whether it's because you're joining a different employer or retiring.
"If you're leaving an employer, it may be very smart to frontload," said St. Martin. "A new employer may have a waiting period for a new plan, or maybe you're retiring and you won't have a plan at all."
Employees, she said, "may like to front-load to take advantage of the pre-tax savings" if they won't have access to 401(k) plans later in the year.
When you're determining the size and schedule of your 401(k) contributions, consider checking with your company's human resources department to learn more about the structure of your 401(k) plan's employer matches. Here are a few questions to ask:
- What is the match formula used?
- How often are matching contributions calculated and made? Per pay period? Monthly? Quarterly? Annually?
- Do you provide true up contributions?
Small differences in retirement savings habits can have a big impact over time, so it’s important to always be on the lookout for ways to maximize the impact of your 401(k) contributions.