How Maximizing Your 401(k) Early Leaves Free Money Behind
Many of us have an employer retirement plan that has a company match. I am talking about a 401(k), 403(b), 457, or TSP plan to name the most popular flavors out there. If your company matches your plan contributions on a paycheck-by-paycheck basis and you set up your contributions to try to hit the maximum deferral limit earlier in the year, then you could be missing out on the full employer match you are entitled to.
Let me give you an example using a 401(k) plan, but it applies to most of the employer plans I mentioned above.
Let’s say that you are 45 years old, make $150,000 per year, contribute 20% of your income to your 401(k), and your employer matches 4% of your income every paycheck. The 4% match you are entitled to is $6,000 ($150,000 x 4%).
Well, 20% of $150,000 is $30,000. If the maximum annual contribution that year is only $22,500 (2023 limit for those under age 50), and you are contributing 20% of your income, you will have reached your $22,500 maximum in 9 months (assuming your income and contributions are spread out evenly over the year), and then you will have to stop making contributions. After you stop making contributions, there’s a chance your employer might also stop making matching contributions…because they don’t have anything to match. If your employer stops making matching contributions, you will have missed out on the final 3 months’ worth of matching contribution, or in this case, $1,500 in free money.
This problem doesn’t affect all 401(k) plans, so here’s what to look for.
If your 401(k) plan has what’s known as a “true-up” contribution/feature, you should be fine. This provision should make sure you don’t miss any matching contributions you would normally be entitled to, even if you max out your 401(k) plan before the end of the year. Any “true-up” contributions are normally made at the end of the year, or at the beginning of the next year. You can find out if this feature is in your plan by contacting your Human Resources department.
Another thing to pay attention to is when does your employer make the matching contributions? If your employer matches your contributions every pay period, that could be a problem. Because then the matching contributions stop when your contributions stop. If your employer makes a one-time lump sum matching contribution, usually at the end of the year or at the beginning of the next year, then you are most likely okay.
What you should do: Spread out your 401( k) contributions. If your employer does not have a “true-up” provision or does not do one-time lump sum matching contributions, then you need to spread out your contributions over the full year. Don’t max out your 401(k) plan early in the year. To figure this out, divide the maximum annual contribution by your annual income. So, in the example I used above, you would divide $22,500 (annual maximum for anyone under age 50) by $150,000 (annual income). In this case, this person would want to contribute no more than 15% of their income ($22,500/$150,000 = 15%). At 15%, this person would max out their 401(k) plan at $22,500 and spread out their contributions over the full year so they don’t miss any employer matching contributions. Problem solved!
If you have already contributed to your 401(k) plan this year before reading this, here is the formula for how to figure out what to change your contributions to for the rest of the year
- First, calculate your remaining contributions for the year = Annual Limit – YTD contributions
- Second, calculate your remaining income for the year = Annual income – YTD Income
- Divide the remaining contributions for the year by the remaining income for the year to find the percentage you will want to save at per pay period for the rest of the year. Be sure to reset your contributions again on January 1st.
Let’s not leave free money on the table. Good luck and happy saving!
