Saving Too Much Too Early in the Year Can Hurt Your Retirement

When it comes to retirement planning and building up the proverbial nest-egg, there are few pieces of advice more universally accepted than “save as much as possible as early as possible.” Certainly, taking such action is often one of the best ways to grow your retirement savings, but like nearly all generic statements about how “you” should plan for retirement, there are exceptions to the rule.

Failure to identify and understand when those exceptions apply may leave you with less money to spend and enjoy during your golden years. Case in point: Contributing too much to your 401(k) or similar retirement plan too early in the year may be hazardous to your retirement-savings health.

How so you ask? Because by contributing too much, too soon to your 401(k) or other retirement plan, you can potentially reduce the amount of so-called “free money” you receive in matching contributions from your employer.

2021 401(k) Contribution Limits

401(k)s, like most tax-favored accounts, limit the amount of money that you can contribute each year. For 2021, the maximum amount of salary that can be deferred into a 401(k) is $19,500. If you are 50 or older by the end of the year, you can add an additional $6,500 “catch-up contribution” as well, bringing your total 401(k) salary deferral limit for the year to $26,000. It’s also worth noting that if your 401(k), 403(b), Thrift Savings Plan, or similar retirement plan has a Roth option, the $19,500/$26,000 limit is total amount of salary that can be deferred into both the Roth side of the plan (i.e., the Roth 401(k)) and the traditional side of the plan, combined.

You may also be familiar with the “overall limit,” also known as the “limit on annual additions,” which is the maximum amount of total contributions you can receive in your 401(k) for the year from all sources, including your own salary deferrals, as well as employer matching contributions and profit-sharing contributions. For 2021, the overall limit is $58,000 ($64,500 including catch-up contributions).

How Contributing Too Much Too Soon Can Reduce Employer Matching Contributions

About half of all 401(k) plans offer some sort of matching contributions, where the plan sponsor (your employer) will use a formula to deposit funds into your account based on how much you contribute for yourself. Many people believe that, as long as they contribute “enough” into the plan, they will receive the maximum employer matching contribution. But the reality is that in some cases, it’s not just about how much you contribute to your plan, but when those contributions occur.

Incredibly, in some situations, contributing too much to your 401(k) or other plan too early in the year can cost you. Those with higher incomes are often more at risk of running into this problem, simply because they have a greater ability to “fill up” their 401(k)-salary-deferral “bucket” early in the year.

The key problem is that while plans can handle the calculation and mechanics of matching contributions in different ways, many plans calculate those matching contributions on a per-pay-period basis.

“What does that mean?” you ask?

Simply that if your employer matches a specific percentage of your salary, they may only match you up to that percentage on each your checks, and not on how that check amount related to your total annual salary. That’s complicated, I know. So let’s take a look at an extreme example to make the point crystal clear.

Example: John is a 60-year-old executive at a large firm. In 2021 John’s salary is $840,000 (good to be John, right?), which is paid to him in bimonthly (twice per month) installments. Therefore, the gross amount of each of John’s 24 checks for 2021 will be $35,000 ($840,000 salary/24 checks = $35,000 gross amount per check). Furthermore, John’s employer offers a 401(k) with a 5% dollar-for-dollar match, but like many employers, it applies that match on a per-pay-period basis.

Because John in 60 and is nearing retirement, he’s looking to do whatever he can over the next few years to maximize his savings. And he’s always heard that contributing as much as possible as early as possible to a retirement account is a good way to go. As such, right before the start of 2021, John reached out to his plan and changed his deferral percentage to 100% of his salary.

Notably, because each of John’s paychecks are for $35,000, at a 100% contribution rate, John will fully fund his maximum 401(k) salary deferral of $26,000 after his first paycheck! In a vacuum, this sounds great.

But we don’t plan in a vacuum. We plan in reality! And in reality, what happens is this.

John’s employer will look at his $35,000 paycheck and match 5% of that amount, or $1,750. And that will be the total amount of matching contributions that John will receive for the year. Since he will not be deferring any more of his future 2021 salary to his 401(k) – because he can’t, as he’s already deferred the maximum amount – his employer will not make any further matching contributions for the year.

Pretty lousy, huh?

Consider that 5% of the maximum $290,000 of compensation (an inflation-adjusted limit set annually by the IRS) that can be considered in 2021 for the purpose of calculating John’s match yields a maximum match of $14,500. That’s a far cry from the $1,750 that John will get for the year. Put differently, John’s zeal to fund his account as early as possible cost him $12,750 in missed “free money” employer matching contributions.

Planning to Avoid Missing Out on Matching Contributions

Missing out on a significant employer matching contribution because you were too eager to fund your retirement account can be a tough pill to swallow, and frankly, doesn’t seem very fair. That’s why some plans incorporate something known as a “true-up” provision.

In plans with a true-up provision, the plan will review contributions at the end of the year and treat them as though they were made throughout the year. Thus, for individuals like John, from our example above, early-in-the-year-front-loaded deferrals won’t permanently result in lost matching contributions, but rather just a delay in receiving them.

The true-up provision, however, is an optional feature of a plan, and as you might surmise, many plans don’t include it (it is, after all, a way for the employer to potentially save making some matching contributions, reducing their cost of the plan). Thus, in such situations, it’s critical to ensure that you take proper planning to avoid the unwanted loss of matching contributions.

The easiest way to avoid falling into the deferring-too-much-too-soon trap is simply to slow down your rate of deferral. For instance, instead of contributing 100% of his salary, John, from our example, could have opted to only defer $1,500 from each of his checks into his 401(k) plan. With 24 total checks for the year, that would have still been more than enough to “max out” his $26,000 of allowed salary deferral, but it would have also been slow enough to allow him to receive the maximum employer match of $14,500 for the year.

We’re still in the early stages of the year, so now is a great time to check your salary deferral rate and your plan’s terms to make sure you don’t miss out on any potential employer matching contributions.

Looking at an extreme example, like John’s, makes it easier to see the potential impact that contributing too much, too soon can have on your retirement savings. Your situation may not be anywhere near as extreme, but how much employer money are you willing to pass up before you think it’s “too much?”

My guess, is “not much.”

Jeffrey Levine is the Chief Planning Officer for Buckingham Strategic Partners.

Beacon Hill Private Wealth is an independent, fee-only, fiduciary investment advisor providing evidence-based wealth planning solutions that simplify our clients' financial lives. Founder Tom Geoghegan, CFP® CPWA® MBA is also a member of the National Association of Personal Financial Advisors (NAPFA).

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The information presented here is for educational purposes only and should not be construed as specific investment, accounting, legal or tax advice. Certain information herein is based upon third-party information and may become outdated or otherwise superseded at any time without notice. Third-party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. The example showing John’s 401(k) contributions is hypothetical; individuals should speak with a qualified professional before making changes to their contributions and portfolios. The opinions expressed by featured authors are their own and may not accurately reflect those of Buckingham Strategic Partners.

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