401(k) plans can be the most useful tool you have in saving for retirement. With these tax-favored retirement accounts featuring ultra-high contribution limits of $18,500 for those who are younger than 50 and $24,500 for those who are 50 or older in 2018, well-off workers often seek to max out their annual 401(k) contributions. Moreover, the fact that many employers add their own matching contributions to the money that you set aside from your own salary is just icing on the cake for retirement savers.
Yet there’s a trap for those unwary supersavers who seek to set aside as much as they possibly can in a 401(k). If you’re not careful with how you manage your savings over the course of the year, you can end up missing out on a portion of the employer matches that you’d otherwise be entitled to receive. Fortunately, it’s not hard to find a way around this problem once you’re aware of it, but if you don’t act, it can cost you thousands of dollars in missed matching contributions.
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The way matching contributions work
Many employers choose to provide matching contributions in order to give their workers more incentive to save toward retirement in their 401(k) accounts. Typically, an employer that offers matching contributions will pick a certain percentage of your salary that it will match, along with the proportion of your own contributions it will match. Some employers match your contributions on a dollar-for-dollar basis up to a certain maximum amount, while others will provide a different amount, such as $0.50 for every $1 you contribute.
For example, one common matching provision involves employers matching the first 6% of your salary, either with $0.50 or $1 for every $1 in your own contribution. So, if you make $60,000 and get paid once a month, you could choose to contribute 6% of your $5,000 monthly paycheck, or $300. Your employer would then match that with an employer contribution of $150 or $300, depending on the matching provision. Over the course of the year, that’d add up to contributions of $3,600 from you and either $1,800 or $3,600 more from your employer in the form of matching.
However, you could save a lot more than $3,600 if you wanted to. If you set aside 30% of your pay, you’d have total annual contributions of $18,000 — just below the $18,500 maximum for 2018. You’d still get the same match, though, because it applies only to the first 6% you save in your 401(k).
The problem with supersavers
Neither of the two examples above risks losing any employer matching contributions. But a potential problem comes in if you max out your 401(k) early. That’s because once you hit the yearly contribution maximum, your employer will stop taking money out of your paycheck to go toward your 401(k). In some cases, employers also then stop the match — they haven’t yet matched the given percentage of salary.
For example, take the same example above where you save 30% of your salary, but assume that you make $92,500 instead of $60,000. Your monthly pay of just over $7,700 would lead to monthly contributions of $2,312.50, and if you had a dollar-for-dollar match on the first 6% of salary, you’d receive $462.50 in matching contributions. However, at that rate, you’d hit the $18,500 maximum eight months into the year. Beginning in September, your employer would no longer take 401(k) contributions out of your check, and you’d stop getting the $462.50 per month match. For the year, you’d get only eight months’ worth of matching, or $3,700, rather than the $5,550 you should have gotten.
How to fix the problem
To avoid this situation, you have to be smart about how much you save. Specifically, you need to time things so that you max out your 401(k) when you get your last paycheck of the year. That way, you’ll get the full match.
In the above example, if you divide the $18,500 maximum contribution by the $92,500 salary, you get 20%. So to max out your 401(k) with perfect timing, you’ll want to set your contribution at 20% of salary instead of 30%. By doing so, you’d contribute about $1,540 per month, and that’d be enough to get the same $462.50 monthly match. At the end of 12 months, you’d have contributed the same $18,500 maximum, but you’d also have received the full $5,550 available in matching contributions.
401(k) plans are valuable, but you have to know the tricks that can cheat you out of valuable benefits. If you want to max out your 401(k), be sure to do so in a way that avoids missing out on the full amount of the employer match that you deserve.