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.

IRA accounts (Ultra-rich vs Rich vs Poor)

Ever wondered how the Ultra-rich use IRA accounts? And how people with moderate means can also use the IRA accounts? Read on…

In recent past, my Roth IRA account’s worth reached $100,000 so I am personally very excited. I can be considered rich by many standards. Today, we will talk about Roth IRA accounts and how the ultra-rich and rich use it. We will then continue to talk about the middle class and the poor – and explore what can they do to be able to save a little more.

(You can also skip directly to rich or middle class/ poor section if the ultra-rich jugglery does not interest you).

Ultra-rich

Ultra-rich use several different techniques to make the most of Roth IRA possibilities. The most widely used and easiest to understand is “Buying pre-IPO stock that records a 2,000% gain as soon as IPO’.

IPO stands for Initial Public Offering. Any company usually starts because a few like minded people come together and start to create a new product or service. They put some of their money and start the company.

If the idea starts to do well, they will find investors to invest some serious money. Once the company becomes successful, then they go to the ‘stock market’ and sell part of their (owners + investors) ownership to common public through an IPO.

The company has a lot of flexibility in deciding how much to ‘charge’ for the initial distribution of shares.

The name of Max R. Levchin (Yelp) comes up often in these discussions, let us examine what he did:

He acquired Yelp stock mostly for free. At one point, he held about 29 million shares of Yelp.

Yelp went public in 2012 at stock price of $15. This means Max’s 29 Million shares would have been worth $435 Million.
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IRA versus Roth IRA

Deciding factors: if the contribution is deductible, tax bracket in retirement versus tax bracket today, income levels today, current age, and availability of  retirement plan at work.

If the question is whether you should invest in an IRA account (including traditional and Roth), then the answer is YES (capital bold yes)*. If the question is whether you should contribute to a traditional IRA or a Roth IRA, then the answer is ‘it depends’.

It primarily depends on several factors. Two of these factors are the most important: whether the contributions are taxable in the current taxable year, and whether you expect your tax rate to be higher or lower (as compared to the current rate) in retirement.

The basic idea of an IRA account (traditional and Roth) is 'Money is taxed by the IRS only once' - either you get taxed now OR you get taxed when you withdraw the money in retirement.

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My Roth IRA crosses $100,000 (2011 – 2015)

From $0 in 2011, my Roth IRA reached $100,000 in 2015. I will explain in detail with screenshots everything that I did in these 4 years.

The below table summarizes the entire process from 2011 – till date 2015:

Six Figure Roth IRA ($100,000+)

Six Figure Roth IRA ($100,000+)

We will get into specific details but broadly speaking here is what I have done:

  1. Maxed out my Roth IRA contributions in 2011
  2. Maxed out my Traditional IRA contributions and rollover over to Roth every year (2012 – 2015)
  3. I maxed out my After-tax (Thrift) contributions to the 401k plan
  4. Periodically rolled over the After-tax 401k money to Roth IRA (paying taxes on earnings)

Let me break up the above table and explain each section in a little more detail, along with my commentary. Continue reading

Back door entry to the Roth IRA?

Anyone can contribute to a Roth IRA, irrespective of their income. It is true that IRS has an income limit on who can contribute to the Roth IRA but it has a really neat (and simple) workaround.

For the year 2015, IRS rules (IRC – Internal Revenue Code, to be specific) specify that single filers making more than $131,000 and married filers filing jointly making more than $193,000 cannot contribute to Roth IRA.

Now here comes the neat trick and it has two parts - contribute to traditional IRA and do a Roth conversion.

Yes, it is that simple and achieves what you would have achieved by being able to contribute directly to a Roth IRA. Once the money is in Roth IRA, the money is there in the Roth IRA – irrespective of whether you made the contribution from your checking account or a rollover from your traditional IRA account.

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What to do with old 401k?

With more and more employers offering 401k plans AND more and more employees changing jobs frequently; you are bound to be asking yourself the following question:

What should you do with your ‘old’ (previous employer) 401k account?

There are 5 options:

Option 1. Leave it where it is
Option 2. Roll over to new employer 401k
Option 3. Roll over to your IRA account
Option 4. Roll over to your Roth IRA account
Option 5. Cash out

A selection needs to be made keeping in mind these 5 factors:

A. Quality of investment choices in the old 401k
B. Quality of investment choices in the new 401k
C. ETF v/s stock picking
D. MAGI consideration – back door entry to Roth IRA
E. Administrative convenience – one less account

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