Earn Extra in 401(k) every year at Catch a Gideon

October 28th, 2006 by digerati

Props to Frugal for quantifying this. I’m going to use his numbers because they are nice and round.

The limit in 2006 for 401(k) contributions is set at $15,000 for individual contributions. There are some ways to increase the total contributions (currently capped at $44,000 per year).

employer matching - many (most?) employers offering 401(k) (or 403(e)) plans will match a percentage. I’m looking at having the first 3% matched entirely and then half of the 4th and 5th percents matched as well. This is the best possible investment I’ve seen since it is a guaranteed 100% return on what you contribute, plus the interest or investing of that money will accumulate tax free.
contribute to the plan as a small business owner. If you own a small business you are able to contribute to a 401(k) to your employees (including yourself). This may take some creativity and I’ll talk about this in another post, once I’ve figured out how to do it right.
Contribute to your account as much as possible early in the year. That’s what this post is about.

We’ll take a salary of $60,000 for the example and assume that you are allowed (by your company) to contribute up to 100% of your salary to the 401(k) plan. Note that often companies put a cap on this amount. Frugal says his company caps him at 60% of his total salary.

To maximize the contribution one should contribute the maximum possible until the account is full (the $15,000 for the year). To do that you contribute 100% of the earlier pay checks to the 401(k). Realize that this requires you to have enough money is savings (or enough credit) to sustain yourself until you are receiving income normally again. At a 100% contribution and $60,000 salary you can do this in 6.5 pay periods.

The table below assumes that the contributions are earning an average of 5.0% APR.

Successful Personal Finance - 401k increased contributions

Since the money placed in the account is earning interest tax free (as opposed to the income you have saved outside the account) you earn more relatively than you would have otherwise by filling the account over 26 pay periods as you normally would. The increase is about $300. I don’t need to remind you that when that is compounded over many years it will be a significant amount.

The one problem I see with this is that an employer who matches contributions may do so at each pay period. So if you contribute nothing after period 7 then you get no matching after that. I have not calculated how this would work out optimally. Has anyone else?