Should you front load 401k contributions?

Should you front load your 401k/ IRA contributions? Most certainly yes, given a few caveats.

In general, there is little doubt that you should front load your 401k contributions as soon as possible in the year rather than distribute it over the 12 month period.

Note: Although this post is about 401k, most of it is equally applicable to IRA contributions as well.

Most of this post will assume that you have the money to contribute (for many the money left after their living expenses might not be sufficient to contribute what this post might suggest. Please make changes accordignly.

Now coming to the two main reasons why you should front load your 401k contributions:

  1. Tax Reasons
    All the retirement accounts offer some kind of tax advantage, either they are tax deferred or tax exempt. You can read more about them in my earlier post Big difference between death and taxes.
  2. Reasons relating to job uncertainty
    What if you lose your job (or quit)? You can contribute to a 401k only while you are employed.

Tax Reasons

Contributions to 401k are tax deductible. This means – when you contribute $12,000 to your 401k in 2017; the $12,000 will be reduced from your taxable income for 2017.

The tax-deductibility of this $12,000 does not change whether you  contribute $500 every paycheck OR you contribute $2,000 per paycheck from Jan to Mar.

Here is what changes: The taxes you pay on the earnings. One fundamental thing to keep in mind here is – if you do not contribute to the 401k, you (hopefully) are investing the money elsewhere (in a taxable account).

Assuming you save $24,000 per year ($2,000 per month). Here are two possible scenarios: In one scenario, you contribute uniformly $1,000 each month to your 401k and the rest to your regular investment account. In the other scenario, you contribute $2,000 to your 401k for the first 6 months (and nothing to the regular investment account).

End of the year – you have contributed $12,000 to 401k and $12,000 to your regular trading account in both the scenarios. BUT the earnings in 401k are not taxed until withdrawal but earnings in regular trading account are taxed when they occur. Assuming 12% earnings and 25% tax rate, here is what it looks like:

So you save $95 in additional taxes just by contributing to the 401k more during the first half of the year rather than uniformly throughout the year.

Reasons related to job uncertainty

This is specifically applicable to 401k (and not to IRA). You can contribute to your 401k only through your paycheck. That implies that you cannot contribute to your 401k as soon as your paychecks stop.

Now this job termination can be voluntary or involuntary. There is always a possibility that you might get terminated or you might choose to switch jobs (and your new employer might not offer a 401k plan).

In either scenario, you lose your ability to contribute to 401k.

In certain special scenarios of job change, it is possible that you maxed out your 401k at the first employer BUT the 401k at the new employer is even better. In that case, you work with your first 401k plan administrator to withdraw your contributions (and earnings) in the first plan so that you can contribute to the second plan.

OneMoreDime Special – There is only caveat to the 401k front loading logic: if you start a new job and your employer matches your 401k after a certain period of time, then this might backfire. Below is an example.

For example: You start a new job on 5/1/2015 and your employer will match your contributions AFTER 1 YEAR up to 50% of 5% of your base salary (this is the industry standard now days). That means for someone with a base salary of $100,000, the employer will match up to $2,500 of the contributions.

Since the employer’s 401k match will start after 1 year, they will match contributions only after 5/12016. If you make the entire $18,000 contribution in January – April time frame, you will not get a match. And remember – employer’s match is free money.

Front loading retirement account contributions

My ex-employer’s 401k match policy

I can count on finger tips the number of financial mistakes I have made in my life, this is one of them – I lost money, I contributed too soon and did not get the employer match. On the right, you will see an actual screen shot of my employer’s 401k match policy (I have just replaced the actual employer name by the word ’employer’).

Another version of this ‘problem’ is – some employers contribute on a per pay check basis, so they contribute 50% of 5% of PER PAY PERIOD base salary. They contribute only when you contribute (even though they might deposit the match only once a year, they calculate it per pay check).

Talk to your HR about the employer’s match, once that issue is resolved, go for it !

Real-life Case Study

Situation: One of my blog readers (we will call him Aaraon) asked the following: I started a new job on 1/2/2017 with an annual base salary of $120,000. My employer matches dollar on dollar per paycheck for the first 1% contribution and then 40 cents to a dollar for the next 5%. Assuming I want to max out my 401k contributions, what is the best plan (timing wise)?

Analysis:

  1. In order to get the maximum tax deduction in 2017, Aaron has to contribute $18,000 during 2017.
  2. Company PER PAYCHECK matches upto 6% of salary if the employee contributes.
  3.  Although Aaron did not mention it in his first message, follow up discussions revealed that his employer permits 0% to 50% (of income) contributions to 401k per paycheck.

Company match is free money, in order to get the company match Aaron necessarily has to contribute 6% of salary each paycheck. Per paycheck salary is $5,000 ($120,000 divided into 24 paychecks).

6% of $5,000 is $300. So Aaron necessarilyhas to contribute $300 each paycheck. That will amount to $7,200 for 2017.

IRS limit for 401k currently is $18,000. That implies, he can contribute $10,800 more.

He should contribute this $10,800 as early as possible in the year. Here is where the 50% employer cap comes in.

He can contribute only a maximum of 50% of salary per paycheck. So 50% of $5,000 = $2,500 per paycheck.

Solution

Here is what an ideal situation looks like: He contributes $2,500 for the first 4 paychecks (Jan and Feb). That is a total contribution of $10,000.

The remaining $8,000 can be contributed over the remaining 20 paychecks – $400 per paycheck.

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