For many of us, our 401(k) or similar employer-sponsored retirement plan is our main vehicle for retirement savings. A 401(k) plan is a defined contribution plan meaning that our retirement benefit is determined primarily by the amount that we save in the plan and how we invest those savings.
These types of plans have largely replaced pension plans of our parents and grandparent’s generation which were largely funded by our employers.
Ideally you got started saving for your retirement in your company’s 401(k) plan right out of the box when you started working. If not hopefully by now you have gotten going and this is a regular deduction from each paycheck.
It’s not easy to do when you’re in your twenties. There are plenty of other things on your mind than saving money out of your paycheck that you’re not going to touch for the next 30-40 years. In our instant gratification society, it’s a tough pill to swallow and an even tougher concept to teach.
However, if you’re reading this today, then you’re probably well on your way to contributing to your 401(k) and, most likely, maxing it out on an annual basis. To that, I say congratulations… you have made a great achievement.
For 2020, the new maximum contribution has increased to $19,500. And, if you are 50 or older, then you can contribute an additional $6,500 for a total of $26,000. That’s a lot of money on an annual basis.
On top of that still, you have your employer’s matching contribution – if you’re lucky enough to have one. For most 401(k)’s, that’s typically in the 3-4% range – if you’re getting more than that, then you should give your employer a nice big hug because they are more generous than others.
Now, you might be asking yourself, “So, if I’m maxing out my 401(k) annually and getting matching contributions from my employer, what is the issue?” You wouldn’t think there would be an issue and I never did either until I started to do a little research into how some employers match contributions.
There are really two issues at hand here:
1. How your employer contributes the match – lump sum or every paycheck
2. When you max out your 401(k) during the year
So, let’s start with number one. If your employer is simply putting in one lump-sum of matching contributions for you – typically at the beginning of the following year – then you are all good, and there’s nothing to worry about. You are getting your full match and can stop reading – but, you’ve made it so far, so you might as well expand your knowledge just in case you change jobs.
The issue is if your employer is making their matching contributions on a paycheck-to-paycheck basis; which I would say is much more common than the lump-sum matching. So, if your employer matches every paycheck, then you definitely need to keep reading.
Now, let’s look at issue number two. If your employer makes their matching contributions every paycheck, but you don’t max out your 401(k) at some point during the year, then you’re in the clear.
But, if your employer makes their matching contributions every paycheck and you max out your 401(k) at some point during the year, this is where there could be an issue.
Just think about it for a second.
Okay, if you didn’t have that “aha” moment yet, then let me help. If you’re no longer contributing to your 401(k) because you’ve maxed it out for the year, then you’re no longer going to be receiving your match because you’re not making any more contributions!
If your employer makes matching contributions on a paycheck-to-paycheck basis and you don’t have any contributions being made, then, as crazy as it sounds, they aren’t going to make their matching contributions either! I know, it was pretty eye-opening for me when I was doing the research.
So, if you’re one of those people who try to max out their 401(k) as early as they can during the year – or even if you just end up maxing out later in the year – then you could be missing out on a serious amount of matching money and, even worse, the compound growth of that money.
Let’s take a look at an example so you can see it in real life. Let’s say you make $360,000 a year all in – including salary, bonus, commissions, etc (I know it’s a big number, but it makes the math easier).
Because you’ve always heard that you need to save at least 10% for retirement, you contribute 10% to your 401k, and your employer provides a match of 4%. Let’s say you get paid once a month, and your employer makes their match once a month right alongside your contribution.
So, that would mean you contribute $3,000 a month to your 401k, and your employer contributes $1,200. At the 2020 maximum of $19,500, you would have contributed the max in your July paycheck. At that time, your employer would have contributed a little over $7,200 – let’s just call it $7,200 to make things simple.
While $7,200 is nice, YOU’RE ACTUALLY MISSING OUT ON ANOTHER $7,200 FOR THE LAST SIX MONTHS OF THE YEAR! That’s right; you could have been doubling your match had you just spread out your own contributions – which again, I’ve never known anyone who was aware of this issue.
But, I don’t blame you because you just thought you were doing the right thing by saving for your retirement the way you were taught. If no one ever told you this was happening, which rarely happens from an employer standpoint (because they’re not required - which just doesn’t seem ethical), you’re probably never going to find it out.
To make things even worse, you’re missing out on the compound growth of that $7,200 every year. IF YOU MISSED OUT ON THIS $7,200 FOR 20 YEARS AND AVERAGED A 7% RETURN, YOU WOULD HAVE MISSED OUT ON $315,829!
It’s actually way more than that because I’m not even including the growth you would still get once your contributions stop at retirement. WE’RE TALKING HUNDREDS OF THOUSANDS OF DOLLARS!
First of all, you need to check with your employer to find out how and when they match your contributions. If they do it once a year as a lump sum, then you’re in the clear.
If they do it on a paycheck-to-paycheck basis, then you just need to do a little math to find out the ideal contribution so you can get the full – or close to the full – company match.
Let’s go back to my original example and run some numbers. We need to divide $19,500, the max, by your annual income of $360,000. This comes to about 5.4%. This would be the amount you would want to change it to in order to spread out your contributions over the entire year, ensuring yourself of getting the full $14,400 match (on a side note, your 401(k) may not allow you to contribute a tenth of a percent so I would simply round up to ensure you get the full match...in other words, go with 5% the entire year and then bump it to 9% in December before moving it back down to 5% in January and bumping it to 9% again in December).
And, that’s it. THIS ONE SIMPLE CHANGE OF SPREADING OUT YOUR 401(K )CONTRIBUTIONS OVER THE ENTIRE YEAR COULD SAVE YOU – AND BRING YOU – HUNDREDS OF THOUSANDS OF DOLLARS IN THE LONG-TERM.
It seems so simple, yet not many of us really think about it because, again, it feels like we’re going above and beyond if we max out our 401(k) as early as we can in the year (on another side note, if you work with a financial advisor and they haven’t told you this, then you might want to pass this along).
Good luck and go get your full match!
*There is a caveat called the “true up” provision that some employers have chosen to implement. It’s not required but rather just a selection within the 401(k) plan document. I’ve found that most employers opt out of the “true up” feature.
However, if your employer does have the “true up” provision in their plan, then they are required to go back each year and give you your full match. So, you’ll definitely want to check on that. If they don’t offer a “true up”, then you might want to encourage them to consider it.
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