401(k) Planning: How Funding too much Early can Cost You
For most people, the biggest challenge in retirement saving is maxing out their 401(k) plan. That said, for some – typically highly compensated employees – front-loading their 401(k) contributions can cost them some of their employer match.
For context, let’s first examine the maximum deferral limits into a 401(k) in 2023:
- Maximum Contribution Limit: $22,500
- Maximum Deferral (415) Limit: $66,000
- Catch-Up Allowance: Additional $7,500 for those over 50
How do these numbers impact each other?
Let’s say John is a 55 year old executive that earns $290,000 per year and his plan provides a 3% employer match and a 5% profit share contribution. John can contribute $30,000 (the $22,500 contribution limit plus the $7,500 catch-up amount) and his employer will match $8,700 and provide a $14,500 profit sharing contribution. Given the total of $53,200 is less than the $73,500 ($66,000 plus $7,500 catch-up) he can contribute an additional $20,300 in after-tax contributions if his plan allows.
So how could John have cost himself a portion of the match his employer provided? While plans will differ and the method will be outlined in the plan documents, many plans use a “per pay period” method of determining their employer matching amount. This means that they base the matching funds off of a percentage of that paycheck and you must have made a contribution to receive a match.
Example: John elected to set his deferral to 100% of his paycheck to hit his maximum $30,000 contribution as quickly as possible. He will have maxed his 401(k) out by February but his plan uses a “per pay period” matching method. Because he does not have any contributions going into the plan from March until December, he will not receive matching contributions from any of those paychecks. Since he did not make contributions on the last 20 paychecks of the year he will miss out on $6,960 in employer match money (out of the possible $8,700).
If your employer uses this method of determining employer match you will want to slow your deferrals to last over the course of the year. By ensuring that you contribute at least the deferral percentage required to get the full employer match on each paycheck you will ensure that you are able to receive all matching money available to you.
Example: John wants to ensure he get’s the full 3% employer match available to him. In order to contribute $30,000 over the full course of the year he will set his deferral rate to 11%. By doing so, he will hit $30,000 on his last paycheck and because he contributed at least 3% on each paycheck he will have received the employer match.
As you examine your 401(k) and the potential cost of front-loading, you’ll want to note the difference between an employer match and a profit sharing contribution. We have been reviewing employer matching throughout the course of this post, profit sharing on the other hand is an employer contribution of a percentage of your eligible income and is unaffected by your contributions. If you are unsure whether you may be losing matching funds by front-loading, schedule a meeting to review your plan.
Disclosure: The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, I is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of Michael Dunham and not necessarily those of Raymond James. Every investor’s situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. Prior to making such an investment decision, please consult with your financial advisor about your situation. Raymond James and its advisors do not offer tax or legal advice. You should discuss any tax or legal matters with the appropriate professional. 401(k) plans are long-term retirement savings vehicles. Withdrawal of pre-tax contributions and/or earnings will be subject to ordinary income tax and, if taken prior to age 59 1/2, may be subject to a 10% federal tax penalty. Matching contributions from your employer may be subject to a vesting schedule. Please consult with your financial advisor for more information.
