Wednesday, October 21, 2015

Don't Leave Money On The Table: When Maxing Out Your 401(k) Might Lose You Money

I came across this post on Reddit and it made me aware of a potential situation where you might lose money if you max out your 401(k). I'll recap the post here and try to explain things in a more clear manner (at least to me) than the original author has. The numerical examples I use are the same ones he used.

If your employer offers a 401(k) match AND you are maxing out your 401(k) contributions, you may find your self in a situation where you might miss out on some of that matching money. Now, to be sure, this is going to be a situation few people find themselves in - I personally don't know anyone who is maxing out their 401(k) contribution - but it's worth mentioning in case someday you are able to.

The Problem Scenario

Here's the setup: the IRS has set the maximum amount you can contribute to a 401(k) at $18,000 for 2015. (OK, technically Congress set the limit via law, but the IRS enforces it.) This limit does NOT include any matching funds your employer contributes. Let's assume your employer will match your contributions up to 5% of your salary. The actual amount of the match doesn't matter in this scenario, but we'll go with 5% to have some numbers to work with.

You're a great saver with a high income and have elected to contribute 25% of your $104,000 salary to your 401(k). You get paid biweekly, which means you get 26 paychecks per year. Your pre-tax per paycheck earnings are $4,000, so your 401(k) contribution is $1,000 per paycheck. Each paycheck, your employer matches your contribution up to 5% of your pay, which means they contribute $200 per paycheck (5% of your $4,000 paycheck).

Because the IRS limits you to $18,000 in contributions, after your 18th paycheck, your 401(k) contributions will stop. Once those stop, there is no contribution for your employer to match, so for paychecks 19 through 26, they don't contribute anything. So you've lost $1,600 in matching contributions (8 paychecks times $200 per paycheck).

Now, if your employer is on top of things, they should realize this and at the end of the year, they would make a final "catch-up" contribution to true up. This is because they have agreed to match 5% of your salary and, after their contributions stopped at the 18th paycheck, they have only contributed $3,600, which is less than the 5% of your salary ($5,200) that they promised.

The question then becomes - is your employer on top of things? Will they realize this and actually make the catch up contribution? Will you remember to check to make sure they did? The end of the year is a hectic time with the holidays and vacations and visiting family. It's easy to forget things. Is this one more thing you want to keep track of? I didn't think so.

Here's something else to consider: what if you leave the company after paycheck 23? You'll miss the end of year true up and I'd be willing to bet no one in payroll will remember to perform an end of employment true up just for you. If you forget to bring it to their attention (and you probably will), you'll have lost out on $1,000 in matching contributions (the company match for paychecks 19 through 23).

How To Fix It

There is a relatively easy solution to this problem: adjust your contribution rate so that you don't hit the IRS maximum until your last paycheck of the year.

The maximum contribution is $18,000, which represents about 17.31% of your pay. Change your 401(k) contribution amount from 25% to 17.31%. You'll still be contributing the maximum amount per year, but now, because you are contributing every paycheck, you'll automatically get your employer match each paycheck and won't have to worry about the missing match scenario, either at the end of the year, or if you leave the company.

Most companies only allow contributions to be specified in one percent increments, so you'll have to go with either 17% or 18%. (If you go with 17%, you'll miss maxing out your 401(k) contributions by about $322.)

Another benefit to this method is you can take a little more advantage of dollar cost averaging because your stock or mutual fund purchases will be spread out over 26 pay periods rather than 18.

Although you are doing great by maxing out your 401(k), don't leave money on the table by inadvertently missing some of your employer match!


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