Watch Out for this 401k Trap Later in the Year

A very amateur picture of the mighty Jerry Dome, where the Cowboys would be crushing the hapless Giants tonight if not for it being an away game

Happy Monday, Folks! Today’s post is not going to apply to everyone. The problem I’m going to address falls into the category of “good problems to have.” However, if it does affect you, it will cost you money if you don’t address it. The post applies to folks who A) max out their 401k contributions, and B) have variable income – commissions, bonuses, etc. For those who don’t fall into both of those categories, don’t feel bad and don’t underestimate what can happen in your life either. This is only the third year this information has applied to me and the year before the first, I never would have seen it coming. This method may seem complex, but it is actually really simple once you understand the concept.

In most employer sponsored 401k plans, employers match some percentage of your contributions. The most common one I’ve seen is 3% if you contribute 6% of your salary, or simply 3% of your salary to keep things simple. Some are more generous than that, and many are less so. But let’s use that for the sake of our example. Let’s say you have a set $100k a year salary and want to max out your contributions for 2019. Since the limit is $19k this year, you would simply need to contribute 19% of your salary, which would both easily cover the 6% requirement to get the entire match and hit the contribution limit exactly by the end of the year. If you did that, you would contribute $19k, your employer would contribute an additional $3k, and your total would come to $22k. Bueno!

But what if your income varies depending on performance and other factors? Herein lies the problem. If you anticipate your income will end up being roughly $100k, you want to max out your contributions for the year, and you subsequently set them at 19% and forget it, one of two things is very likely to happen. Either you’re going to undershoot and leave tax shelter on the table (every dollar you contribute to a 401k reduces your tax liability) or you’re going to overshoot and lose out on some of your potential employer contribution money.

Here are some examples to illustrate the point. Let’s say you end up making $80k. At the end of the year, you will have contributed $15,200, missing out on $3800 of tax shelter. You can multiply your top marginal tax rate by that number to determine how much that will wind up costing you. But regardless, ouch! Now the opposite scenario. Instead of making $100k, you wind up making $120k. You would have contributed more than the maximum $19k at some point, except that whatever company administrates your plan is likely to simply cut off your contributions when you hit the limit. So instead, you would have finished making your $19k in contributions for the year at some point before the end of the year. It’s good to be early, right? Not in this case. Unless your employer “trues up” the match at the end of the year, which I doubt most do, you would have left $600 in employer match on the table. Why? Barring the “true up” exception, an employer matches check for check. In other words, you wouldn’t be getting any match for the $20k you had left to earn after you made the first $100k and had subsequently contributed 19k. Once again, ouch!

So how do I avoid either of these scenarios? I make adjustments throughout the year. At the beginning of the year, I set my contribution percentage as if I were only going to make my base salary. In other words, it is much higher than it will be by the end of the year, but if I don’t make a single dollar in bonus compensation throughout the year, I will still max out my 401k. Then, each time I get a bonus, I calculate how much I have left to contribute for the rest of the year, divide it by the amount of base salary I have left to make, and make the result my new contribution percentage. Admittedly, this is a conservative method. But that’s the way I prefer to operate.

You can modify this system to your liking, and you may have to if your base salary is a relatively small percentage of your total annual income. It just requires a little “guess and check.” For example, if your base salary is $40k and your total annual bonus is typically in the high five figures, you’re not going to start the year contributing 47.5% of your salary. Not only would that make for some very lean times until you got your first bonus, but it would also very likely cause you to eat up way too much of your $19k way too quickly, thus eventually defeating the purpose of the entire exercise once you couldn’t contribute a large enough percentage to get the full employer match without going over the annual limit. So in a situation like that, I would probably just estimate, start out contributing around 15-20%, and adjust as needed to stay on pace.

But one nice side advantage of doing things my way is that as the year goes on, the paychecks get bigger. In my case, the result is that I tend to do more of my after tax investing later in the year since I have more cash coming in the door. But regardless of how you do this, the important thing is that you not leave money on the table – either with your employer, or with the bad guys. I know this may seem like overkill to some of you to save what will likely amount to less than $1k a year, but this is a finance blog. And besides, no one knows what the future holds. When you’re at retirement age, you just might need that money and besides, it will almost certainly have grown considerably by then. Plus, although this took a lot of words to explain, it only takes me maybe fifteen minutes total of calculating and making adjustments throughout the year, so in my opinion, it is well worth doing. Have a wonderful week and go Cowboys!

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