One of the first pieces of financial planning advice is that one should immediately take
advantage of any employer’s matching. However, many individuals who are maxing out their
401(k) early in the year do not realize they are missing part of their employer’s match. It all
comes down to the details. There is a lot of research that loading up your 401(k) early in the
year can be a good course of action versus dollar costing averaging it over the entire year. The
basic principle is the earlier you can get the funds in the market working for you the more impact
compounding will have. Those that can, often look to max out the $19,000 in the 401(k) as early
as possible. However, implementing this strategy based on a general rule of thumb without
considering the specific rules of the 401(k) you are utilizing often leads to individuals missing out
on guaranteed returns from their employer’s match.
How does this occur? Well, many employers place a requirement on their retirement plans that
in order to get the match you must contribute during each pay period. This varies from each
retirement plan but this is fairly common practice in the industry. How does this affect you? Say
you get paid twice per month which comes to 24 pay period throughout the year. You are
making $180,000 per year and your employer provides $0.50 for every $1 contributed up to 6%
of your income “per pay period”. Because of the “per pay period” requirement, this match is
being broken out over the 24 pay periods. This means that you need to contribute at least 6% of
your income on all 24 pay periods through the year to get the full match.
So what happens when you max out your 401(k) early in the year? Say by the end of April, you
maxed out the $19,000 in the 401(k) plan because you were contributing 32% of your $180,000
salary. With getting paid twice per month, you have contributed for 8 pay periods at or above
6% of your income. This leaves 16 more pay periods from May to December. If your employer
only provides a match “per pay period”, you missed the match for 16 pay periods. So that
$5,400 match really becomes about $1,800 missing out on $4,200 of a guaranteed rate of return
along with its future growth potential.
If your employer’s 401(k) plan does require a per pay period for your match, we suggest that
you consider averaging out your contributions throughout the year to get the full $5,400 match.
The damage really comes with missing out on this match over the long term. Now not many
people are able to max out their 401(k) plans early for a really long term so let’s just look at a
ten-year investment time span with a conservative rate of return of 6%. This was calculated
using our internal Future Value Calculator. First, here are the annual contributions of $19,000
from the employee and the $1,800 from the match for ten years.
Next, here are the annual contributions of $19,000 by the employee and $5,400 match for ten
years.
Now, this calculation does not take into account the effect of getting the funds earlier into the
market which can result in faster compounding. However, to suggest that giving up on a
guaranteed rate of return along with its future growth potential for the possibility of a slightly
faster compounding effect based on speculative growth rates is faulty logic. I would argue that
you should focus first on what you can control and take advantage of that. This is why it is
important that you review your employer’s 401(k) plan or have a financial planner analyze it on
your behalf. If the 401(k) plan does not require a “per pay period” match and maxing out your
401(k) plan early does not cause a cash flow issue, then pre-loading can be a valid strategy to
implement.
James Hargrave, MBA, CFPⓇ, CLUⓇ
Director of Financial Planning
