Today employer sponsored 401K accounts are the number one way to both build wealth and supplement your retirement income needs.
It is not unusual to have people retiring today with over a $1M in an IRA, much of this being transferred from an employee sponsored 401K that was converted. While $1M in an IRA might sound like an optimum situation, it may present its own problems when you turn 70 ½ and have to start taking Required Minimum Distributions (RMD), I’ll cover that in a future article. In the meantime let’s make sure you are getting the best deal possible from your current plan.
Are you sure you are getting the maximum employer matching funds? You might be surprised that you could be leaving money on the table.
True-Up 401K Plans
Sometimes an employee can “contribute too fast” into their employer matching 401K account and thereby NOT get the full employee amount. Here’s how it could happen.
Suppose your employer’s 401K program provides a certain percentage match to each employee contribution “per pay period”. If you max out your 401K contributions early in the year and therefore you would stop making contributions, your employer will also stop making matches, assuming the employer’s plan does not provide for “true up” contributions. There is an annual limit on 401K contributions.
Let’s say an employer match’s 50% of Mary’s contribution per pay period, up to 6 percent of her earnings. Mary earning $75,000 a year, getting paid $3,125 twice a month. To contribute enough money to reach the IRS’s $18,000 contribution limit, she would need to contribute $750 per pay period, or 24 percent of her salary. In this scenario, the employer would contribute $93.75 in matching funds per pay period, since 6 percent of the employee’s pay would be $187.50, and $93.75 is half of that.
If, however, Mary decided to contribute $818.18 per pay period instead, she would max out her 401K contributions before the end of the year—by the 22nd pay period of the year, to be exact. For the two remaining pay periods of the year, her contribution would be $0— and her employer’s matching contribution would be $0 as well because there would be nothing to match. That would mean she missed out on an extra $187.50 in contributions.
Whether Mary had decided to contribute $750 or the $818.18 per pay period, she would have ended up contributing the same $18,000 total during the year to the retirement plan. That $187.50 in matching funds might not seem like much, but it can add up over the years—particularly when you factor in the returns you are missing on that money.
While Mary’s example is modest, I can tell you that if you are a high earner and say you get a large year-end bonus in the next tax year the consequences of a 401K front-loading could be a substantial loss of extra matching. Sales people who have “lumpy” earnings throughout the year can fall into this category also.
Some employers include a feature in their 401K plans that allows workers to get the maximum employer match even if they’ve finished contributing to their 401K plans early in the year. This is called a True-Up! They calculate at year end the max amount you should have gotten and contribute this amount to your 401K.
Does your employer offer you a True-UP?