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Maxing out your 401k early in the year can cost you a lot of money if you have an employer match. Without the match, front loading your 401k is worth considering.
It’s common financial advice to max out a 401k. Putting as much away in a tax advantaged account as possible is just smart financial planning. There is, of course, a limit to how much we can contribute each year to a workplace retirement plan. And that has some asking whether they should max out their 401k as quickly as possible or spread out the contributions throughout the year.
The question was first posed to me by a reader named Stu:
“Been listening to your podcast for the last few months and have really been enjoying it.
I wound up maxing out my 401k before the end of the year and that got me wondering if there is any advantage (or disadvantage) to maxing it out as early in the year as possible to take advantage of compounding. The rationale being that the sooner you get the money in there, the more chance it has to grow. Probably a simple excel calculation, but not simple enough for me. Cheers, Stu”
There is an annual limit to 401k contributions. In 2022, the limit was $20,500 plus an additional $6,500 for those 50 or older. In 2023, the limit has increased to$22,500 plus an additional $7,500 for those 50 or older.
How quickly you reach these limits each year is largely up to you. With my current 401k, for example, I can choose what percentage of my income to contribute with each paycheck, up to a maximum of 75%. For those that have the income to reach the 401k contribution limit early in the year, Stu wants to know if that’s a good idea. The theory is that the sooner you put your money to work in the market, the better.
Stu’s question may seem simple at first glance, but it touches on several nuanced issues related to retirement savings: (1) should you max out your 401k at all, (2) should an employer match–for those that have one–affect the decision, and finally (3) Stu’s question related to the benefits of investing as early in the year as possible.
Let’s look at each of these issues.
Listen to the Podcast of this Article
1. Should you max out your 401(k) at all?
Maxing out a 401(k) is not always the best decision. While some workplace retirement accounts of good investment options, many are loaded down with expensive and market underperforming mutual funds. In contrast, with an IRA we get to choose where to open the account, giving us unlimited investment options.
With that in mind, here’s a strategy to consider:
Step 1: Start by funding your 401(k) up to the employer match. If your employer has a 401(k) matching contribution, you should contribute enough to take full advantage of that match. If your employer offers to match your contributions dollar for dollar up to 6% of your pay, for example, then your first priority should be to take full advantage of that match. After all, it’s virtually free money.
Step 2: Max out your IRA contribution – traditional or Roth. Because you choose where and what to invest in with an IRA, you generally get better investment options in an IRA than in the typical 401(k) plan (the government’s TSA is one exception to this rule.).
Step 3: Max out your 401(k) if you have the money.
For 2023, that’s $22,500.
I assume from Stu’s question that he has the money to do all of this. So let’s move to the second issue, the employer match.
2. Employer Match
The employer match warrants special consideration. Contributing early could cost you big in the form of a reduced match.
To keep the numbers round, let’s say that you earn $100,000 per year and that your employer matches your contributions, dollar for dollar, for up to 6% of your salary. That means that the match has a potential benefit of $6,000.
Now let’s assume you contribute exactly 6% throughout the year. At the end of the year, you will have contributed $6,000 (6% of $100,000) and your employer will have matched this amount. To max out your contributions in equal amounts throughout the year, you would contribute 22.5% each pay period (22.5% of $100,000 is $22,500, the 401k limit for 2023). Each pay period your employer would contribute 6%, for a total of $6,000.
But what happens to the employer match if you contribute more than 22.5% each pay period? Let’s look at an extreme example of contributing 50% of your pay. Your monthly gross income in our example is $8,333 ($100k / 12). A 50% contribution would mean adding $4,166 per month to your 401k. The result would be that you would reach your contribution limit in about 5.4 months ($22,500 / $4,166 = 5.40 months).
Now remember, your employer will match your contributions up to 6% of your gross pay, which comes to $500 a month ($8,333 x 6%). It will take you just 5.4 months to reach your maximum contribution of $22,500, after which the employer match will stop because your contributions will stop. That works out to approximately $2,700 ($500 X 5.4 months), rather than the $6,000 that the employer would match over the course of the year.
Not all employer matching programs work this way, but this is how it worked at my last employer. Some employers will complete the match based on your year-end income, but not all. You should find out about this from your 401(k) plan administrator, at least if you plan to max out your 401(k) early in the year.
3. What about the market?
This gets down to the question of lump sum investing versus dollar cost averaging. You can get a more complete discussion of my views on this topic in Podcast 71 which is completely dedicated to the topic. But let’s summarize it here.
Under ideal circumstances, lump sum buying works well if you can buy into the market at the point of the year when stocks are the cheapest. The problem is that we can’t know when that’s going to be. The market goes up in the long term, so in theory, at least, the earlier that you get into the market the better. And of course, you want to take advantage of both tax deferral and compounding of investment returns, too.
Over the long term, it will probably be to your advantage to front-load funding. Lump sum investing tends to outperform dollar cost averaging, at least in many years.
In 2013 for example, front-loading would have worked well because the market ultimately rose 32% for the year. But had you done it in the 2008 – 2009 time frame, it would have been a disaster because the market fell from the beginning of each year.
I think the bigger question in regard to front-loading is how much does it really matter? And I think the answer to that question is, probably not much. I tend to max out my 401k early, but not to the extreme. One year, I maxed out my 401k (which doesn’t have an employer match) in about nine months.
Do you have different thoughts on maxing out your 401(k) early?