This 401(k) Mistake Could Cost You Your Match
Jumping the Gun on Contributions (and Missing the Match)
Most 401(k)s and other employer-sponsored retirement plans work in a similar way. Your employer will set a limit on how much of your contributions it will match, typically either dollar-for-dollar or with a 50-percent match. For instance, one common standard has the employer match every dollar you contribute up to 6 percent of your salary with $0.50 of the employer's money. Consequently, if you earn $50,000, all it takes to max out your match is to contribute $3,000, to which your employer will add $1,500 on your behalf.
For many employees, coming up with $3,000 to contribute can be the biggest challenge they face. But for higher-earning workers, another potential pitfall comes into play. If you contribute too high a percentage of your overall salary early in the year, you can end up maxing out the $17,500 annual limit on 401(k) contributions too early -- and thereby cost yourself some matching funds in the process.
Take an example: A worker who earns $10,000 each month saves 20 percent of earnings in a 401(k) for which the employer matches dollar-for-dollar up to 6 percent of earnings. That means that in the ideal situation, the worker would receive 6 percent of $120,000, or $7,200, in matching contributions. But by saving $2,000 each month, the worker will hit the $17,500 limit after just nine months. As a consequence, that worker might only get credit for nine months' worth of matching contributions, or $5,400, giving up $1,800 in potential matching contributions on the worker's behalf.
The situation can be even tougher in cases involving a bonus payment. Many employers pay bonuses early in the year, and if you arrange to have a large portion of that bonus set aside in a retirement account, it can go a long way toward covering your total allowable 401(k) contributions for the year. If by doing so, you max out your 401(k) early in the year, then you might effectively give up your matching for the months in which you weren't able to make contributions.
What You Can Do to Avoid Losing Your Match
Fortunately, some 401(k) plans have provisions that prevent the loss of your match from happening in the first place. These so-called "true-up" provisions ensure that the employer considers all of your earnings from throughout the entire year in calculating the matched amount, rather than just the months in which you made contributions. So in the example above, the true-up provision would result in the employer adding back the missing $1,800 to reflect your year-long contributions. The point at which the true-up occurs varies from plan to plan, but it typically happens near year-end when it's obvious what each participant has done.
Even if your employer's plan doesn't have a true-up provision, though, there's another way you can make sure you get every penny of matching contributions you deserve. If you monitor your matching to have an equal fraction of the 401(k) contribution limit taken from each regular paycheck and contributed to your 401(k) account, then you'll make sure that you make a contribution each and every month and get the full amount of the match throughout the year.
As hard as it is to save for retirement, you can't afford to miss out on free money your employer provides you. By being smart about your matching, you can make sure that you don't leave any of your hard-earned benefits sitting on the table unclaimed.
Motley Fool contributorDan Caplingeralways has trouble not jumping the gun at races. You can follow him on Twitter@DanCaplingeror onGoogle+. To read about our favorite high-yielding dividend stocks for any investor, check outour free report.