Maxing Out Your 401(k) Early Might Be Costing You
A new client recently asked me if they should max out their 401(k) early in the year to benefit from compounding growth. If the market goes up most years, maxing out your 401(k) as early as possible so all those dollars can grow throughout the year makes sense.
I told them we needed to look closer at their specific 401(k) Summary Plan Description (SPD) – a document that tells you how the plan works and outlines particular plan rules. One of those rules is how the company matching contribution is calculated. There are two ways that plans typically calculate the matching contributions –
(1) Per annual contribution - “If you contribute X amount this year, we will match X amount this pay year.”
(2) Per pay period contribution - “If you contribute X amount this pay period, we will match X amount this pay period.”
For example, your company matches 5% if you contribute 5%. Your salary is $200,000/year ($8,333 bi-weekly). Now, you front-load your contributions and max out your 401(k) ($23,000 for 2024) by contributing 100% for your first 3 pay periods.
You will see that the amount you receive varies significantly depending on how the company calculates the match.
(1) Per annual contribution - You contributed $23,000 (the max), or 11.5% of your pay over the year, so you receive the full 5% match, or $10,000.
(2) Per pay period contribution - You contributed 100% of your pay for the first three pay periods, so you receive the full 5% match for those pay periods ($416/pp or $1,248 total for three pay periods). However, you didn't receive any additional match because you contributed nothing for the remaining pay periods.
If a company does the “annual contribution” method, they will calculate what is known as a “true up” match. If you max out your plan early in the year, they will calculate after the year ends and figure out how much more they need to contribute to your plan to make you whole. Usually, this contribution comes into account in the February/March timeframe of the following year.
The match is entirely lost for plans that don’t have a true-up. Using the example above, you can see how total contributions are a whopping $8,752 less for the employee maxing out his 401(k) early when there is no true-up.
TSP, the government 401(k)- like plan, is one of the largest plans in the US that does not have a true-up. So, federal employees must contribute at least 5% of pay every pay period if they want to get the full match.
Look at your 401(k) SPD and ensure you optimize for the full company match!
Happy planning,
Alex
This blog post is not advice. Please read disclaimers.