Frontload Your 401k Contributions? An Investigation
At time of writing, April 2018, the IRS contribution limit for an individual 401k retirement account is $18,500 per year. This does not include the portion of your income that your employer matches or contributes to in addition to that amount.
As I'm in the process of setting up a new 401k, the thought crossed my mind - is it better to distribute your contributions throughout the year, or to pour in as much as possible and hit the cap at the beginning of the year? I decided to set up a spreadsheet and find out. In the event that your employer doesn't passively penalize you for contributing the cap as soon as possible, I figured the sooner you can get your money into a bull market, the better off you're going to be. If you have $18,500 in an investment account for a full 9 or 10 months, you may be able to make a few percent over your peers that inch their way toward that $18,500 over the course of the entire year.
Keep in mind that if you aren't contributing the maximum allowable $18,500, the gains from frontloading or year-long incriments are going to be negligible. For example, if you only contribute $3,000 a year, frontloading will only yield you an extra $5,000 over the course of working 30 years - which with inflation, barely makes it worth the effort of figuring out.
Let's set up some parameters for our investigation:
1.) Bob makes $100,000 a year, before taxes (nice and round, easy to work with).
2.) Bob's company contributes 100% up to 5% (more than standard I believe, but again a nice easy number to work with).
3.) Bob should be contributing 5% of his before tax income at the bare minimum. Otherwise he's throwing away free money from his company match.
4.) For the sake of simplicity, his income stays the same for 30 years, as does the company contribution. Unlikely, but easier for me.
5.) The IRS contribution limit stays the same over the same 30 years. Also unlikely. Also easier for me.
6.) We'll investigate two appreciation values: a 7% earning market YOY for 30 years, and a 12% earning market YOY for 30 years.
Whew. I think that covers it.
Bob makes 100,000, so that's 26 payments of about 3850 in a year, before tax. Spacing them throughout the year to meet the maximum $18,500, he would deduct 711.50 from each check before taxes and that would go to his 401k.
Now Bob says hey, the market is doing good and it behooves me to put my money in as soon as possible. I have savings so I can suffer a little and contribute my entire paycheck to my 401k in the beginning of the year until I reach the cap, then I'll go back to receiving full pay. With this method, he takes 4.8 pay periods without pay or about 10 weeks, going 100% toward his 401k. He has fully hit the contribution cap by the middle of March every year, and has a little over 9 months to watch his gains take place while bringing home a full paycheck without retirement deductions.
I've placed these scenarios side by side, also factoring in the company contribution, if they match the 5% regardless of whether it is contributed thoughout the year or frontloading.
If the market instead performs at 12% instead of 7%, the gains increase, of course.
Now, over the course of 30 years of these different investing strategies, what is the gain? How much additional money can you expect the account to generate based on the additional capital you raised by frontloading in this way? 7% and 12% markets are shown below.
That's substantial. By using the simple strategy of fronloading your 401 contributions, you could have an additional 300,000 in a 12% market or an additional 66,000 in a 7% market - just from the money that you've made from getting money into the market early. This is agnostic of the actual contributions to your 401k, which if you were contributing the maximum for 30 years would be substantial. Using this shift in investing requires several things.
1.) Your employer matches no matter when you max out the balance for the year. I can't stress how important it is that you confirm this for the company you work for - if they only contribute 5% of your standard paycheck and no more, then these gains would be destroyed because you'd be losing money from what your employer is not contributing.
2.) You have savings or you plan accordingly to have zero income from your job in the months of January, February, and March (or longer if you make less than our friend Bob).
3.) Your own judgement. It could be a bad time to put all your 401k at the beginning of the year if the economy is expected to tank in the next several months. I am not a lawyer or a professional investor, and you use this information at your own risk. I also encourage everyone to double check my calculations and make sure they are correct as I have described here.
The coolest thing about this is that you're taking the same cut from your pay whether you contribute incrementally or all at once - but in one case you can make a couple college educations worth of money, and with the other you make nothing. Not a bad deal if you ask me, and I fully intend to take advantage of frontloading my 401k!