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Monday, January 09, 2006

The 401k Gotcha

There is a little gotcha in my 401k plan that I have mentioned before, but have never really emphasized. Since this is the only 401k plan I have ever participated in, I don't know if its common or unique.

Typically 401k plans offer some % in matching contributions. For example, my 401k plan currently offers a 50% match on the first 6% of your salary that is contributed to the plan. If I earned $100,000 (not saying a do, just using a nice round number for explanation purposes) a laymen such as myself would think that as long as I contributed $6,000 or more to the plan that I would get $3,000 in matching contributions.

Well if you think like I do you would be wrong. The gotcha is that its not the 1st 6% of my salary, but the 1st 6% of each paycheck. This small wording change may not seem like anything significant, but it can have a significant effect (over time) on your retirement savings.

Lets run through an example to see how bad the damage is. Couple of assumptions: 1) in 2005 we will assume a $100,000 salary and assume a 3% salary increase each year thereafter, 2) We will assume that we hit the 401k limit in the end of October so we would miss out on the last 2 months of paychecks each year, 3) we will assume a 50% match on the 1st 6% of each paycheck, and finally 4) the contributions in the 401k plan grow 6%/yr.

Year

Salary

Total Match

Missed Match

Value in 2025

2005

$ 100,000.00

$ 3,000.00

$ 500.00

$ 1,603.57

2006

$ 103,000.00

$ 3,090.00

$ 515.00

$ 1,558.18

2007

$ 106,090.00

$ 3,182.70

$ 530.45

$ 1,514.08

2008

$ 109,272.70

$ 3,278.18

$ 546.36

$ 1,471.23

2009

$ 112,550.88

$ 3,376.53

$ 562.75

$ 1,429.59

2010

$ 115,927.41

$ 3,477.82

$ 579.64

$ 1,389.13

2011

$ 119,405.23

$ 3,582.16

$ 597.03

$ 1,349.82

2012

$ 122,987.39

$ 3,689.62

$ 614.94

$ 1,311.62

2013

$ 126,677.01

$ 3,800.31

$ 633.39

$ 1,274.50

2014

$ 130,477.32

$ 3,914.32

$ 652.39

$ 1,238.42

2015

$ 134,391.64

$ 4,031.75

$ 671.96

$ 1,203.37

2016

$ 138,423.39

$ 4,152.70

$ 692.12

$ 1,169.32

2017

$ 142,576.09

$ 4,277.28

$ 712.88

$ 1,136.22

2018

$ 146,853.37

$ 4,405.60

$ 734.27

$ 1,104.07

2019

$ 151,258.97

$ 4,537.77

$ 756.29

$ 1,072.82

2020

$ 155,796.74

$ 4,673.90

$ 778.98

$ 1,042.46

2021

$ 160,470.64

$ 4,814.12

$ 802.35

$ 1,012.95

2022

$ 165,284.76

$ 4,958.54

$ 826.42

$ 984.28

2023

$ 170,243.31

$ 5,107.30

$ 851.22

$ 956.43

2024

$ 175,350.61

$ 5,260.52

$ 876.75

$ 929.36

2025

$ 180,611.12

$ 5,418.33

$ 903.06

$ 903.06

 

 

Total

$ 14,338.24

$ 25,654.48



(Update for Clarification: Column "Value in 2025" would be the value of the "Missed Match" in year 2025 assuming an annual 6%ROR. So in total the missed match money would be $14,338.24, but could be worth $25,654.48 in 2025. )

In this example, the worker would basically miss out on ~$25,650 in free money over 20yrs of contributing into their 401k plan, just by hitting the contribution limit too early. Who knew that saving too quickly was a bad thing??

This little gotcha will become even more significant for me in 2008, when IBM increases (to replace the pension plan) its matching contributions to the 401k plan.

31 Comments:

  • Hi 2million,

    Is there a reason your "match" under your spreadsheet is only $3,000? Shouldn't it be closer to $5,000 for the 10 months you contribute to the 401K (Assuming 6% match on your paystub with an annual salary of $100,000 (or about $500/month match)). Otherwise I agree with your calculation, and it would appear that pro-rating your 401K contribution over the entire 12 month period would garner you an additional $1,000 in company match.

    By Anonymous Anonymous, at 12:20 PM  

  • That is a much different wording than I have ever had on a 401K plan. It has always been worded "of your base salary" instead of "of each paycheck." However, that means that a paycheck for a bonus or anything else not included in 'base salary' does not have any 401K implications.

    I need some clarification on the penalty as you calculated it, though. You assume you hit the 401K limit at some point in the year and don't receive any more match because of that. If you hit the limit at some point in the year, contributions would cease and you wouldn't get the match anyway regardless of how the match is based.

    In other words, when the 401K limit is hit, you will cease contributing and the match will stop no matter how the plan is worded. Maybe I'm missing something here?

    By Blogger Chrees, at 12:21 PM  

  • The match on my table is $3,000 because the match formula was 50% of the first 6% of contributions so on a $100,000 salary the net 3% match would be $3,000.

    chrees,
    What I was trying to point out was that to me (and others who were confused by this) if I hit the 401k limit I would assume that I was getting the full match by my employer. However, that isn't true - if I hit the match before my last paycheck I will miss out on some of my employer's match. The example I provided was hitting the limit in October vs not hitting till your last paycheck and receiving the full possible match from your employer.

    By Blogger 2million, at 1:12 PM  

  • OK, I'm dense.

    "The example I provided was hitting the limit in October vs not hitting till your last paycheck and receiving the full possible match from your employer."

    But if you hit the limit, you receive the full possible match regardless of whether it is October or December 31 or even January 1, don't you? The only difference would be timing--you wouldn't be in the market with that match for a couple of months.

    Using your example but having someone withhold 15%, they would hit the $3,000 maximum match 20 weeks into the year. But they aren't missing out on any more match because they have maxed it out. Again, obviously I'm missing something here--not trying to argue the point, just trying to understand.

    By Blogger Chrees, at 2:16 PM  

  • chrees - almost there - its probably more my poor explanation than anyhing.

    In response to "But if you hit the limit, you receive the full possible match regardless of whether it is October or December 31 or even January 1, don't you?" - No. Not in my 401k plan. If you hit the 401k contribution limit before the last paycheck you are missing out on the employer match - in this example it would be $500.

    In the example you WOULDN'T get the total $3,000, you would only get $2,500 and miss out on $500 in matching contributions because you hit the 401k contribution limit ($14,000 in 2005) early.

    By Blogger 2million, at 2:33 PM  

  • chrees - let me know if its still not clear - i will come up with a better example to explain if needed.

    By Blogger 2million, at 2:36 PM  

  • Thanks for your patience. I understand now. In other words, you wouldn't want to max out your contribution early in the year. Any paycheck that doesn't have a 401K contribution, you will not get the match. And since the match is limited per paycheck, it DOES matter when you max it out.

    Draw in the little lightbulb flickering over my head...

    By Blogger Chrees, at 2:42 PM  

  • Great! Sorry for all the confusion. Now can you tell me does your 401k plan have the same issue?

    By Blogger 2million, at 3:01 PM  

  • No, that isn't an issue with ours. It is worded as a match on the "base salary" (and of course there is a lot of detail of what is in and isn't in the base salary). So if I were to max out early, I would get the same match if I were to max out on the last paycheck.

    By Blogger Chrees, at 3:12 PM  

  • Ahh that makes sense - I like that feature much better :-)

    By Blogger 2million, at 3:23 PM  

  • I found out today that the employer match does not count toward the IRS maximum contribution in a 401(k). In 2006 I think the limit is $15k. An individual could contribute $15k out of there own pocket plus whatever employer match they receive. So in your example of $3,000 in matching contributions, $18,000 per year could get added to your account balance.

    Maybe you're aware of this, but I think many people may not be.

    By Anonymous Travis, at 6:17 PM  

  • Where do you find out if your company is administrating it one way or another?

    Neo

    By Blogger Neo, at 6:35 PM  

  • It's not just you, or your plan, 2million...most plans administer the company match similar to yours...mine included.

    I got hit twice now by this little monster...nothing significant, but annoying nonetheless.

    The best I've been able to do is to adjust my weekly % contribution so that at year end I max out.

    So either way, its tough...either you miss out on a little of company match or miss contributing the max to your plan...go figure!

    By Blogger bored, at 8:09 AM  

  • Travis - Good point. This seems like an obviously benefical way for companies to help fund retirement - ie contribute more matching to the 401k plan since they aren't restricted by the same contribtuion limit we are.

    Neo,
    I'm not sure the best way to tell how your plan is set up other than going and asking whoever is administering your 401k benefit. I only now this by asking around and experiencing it 1st hand this year past year.

    By Blogger 2million, at 2:25 PM  

  • I've been working in benefits for a long time, and companies can sneak this in without you knowing it. I work for a company that does the same thing. Plus on top of it, the match isn't deposited in your account until 12/31 each year.

    Neo... The only way to get the fine details of your 401(k) plan is to ask for the "Summary Plan Definition" document aka SPD. This document will detail the fine details of your 401(k) including when/how the match is calculated.

    By Anonymous sixpack, at 6:50 PM  

  • 2million,

    This is just an example of complete laziness on the part of your HR benefits department. With the cancelation of your pension plan recently this is an excellent opportunity to start petitioning for change. Don't give up! Luckily my company does it the correct way!

    By Blogger Jeff, at 3:36 PM  

  • One of the big ones that I have been trying to find out is if the annual 401(k) contribution limit includes matches from your employer, or not. If it does not include matches, then I have nothing to worry about, as I will certainly not contribute any more into a 401(k) that I can get matched for. I find it silly to do so because I could have more control if I put it in an IRA. However, I have a great 401(k) program with my employer (I am just waiting to become eligible). I get matched 100% for the first 3%, and 50% for the next 2%. Beyond that, they contributed 8% regardless, and the board votes on an additional 2% (which they have always voted for). So, if I contribute 5%, my employer contributes 14% for a total of 19% annually. Now, hopefully the annual contribution limit keeps increasing by $1000, if my employers match is factored in for my annual limit. I plan on staying with them for at least five years, with a maximum of ten years.

    By Blogger Dus10 D, at 9:25 AM  

  • My plan does the same thing. I try to max out the plan every year, so I have to plan on this. The problem is that I get a bonus in December and never know how much it will be. On top of that, I can't change my contribution level but twice a year, so that essentially means that I have to guess at the bonus and try to leave room under the cap in order to maximize the employer match. Good post.

    By Anonymous Anonymous, at 2:56 PM  

  • but isn't only your contributions being matched? Taking an example, assume you contribute $2000 a month, which would have you maxing out b/f the end of the year, your match should be 2000*.06=120. This is capped by your monthly salary * .6 so your cap is (100k/12)*.6=500. And 120 < 500

    So you will get 6% matching on whatever you end up contributing.

    By Anonymous Anonymous, at 3:01 AM  

  • Not in the 401k plan I currently participate in. In your example of $2000 in monthly contributions (with $14k contibution limit) I would max out and get something like this:
    Month Contribution Match
    January $2,000 $500
    .....
    June $2,000 $500
    July $2,000 $500
    August $0 $0
    September$0 $0
    October $0 $0
    November $0 $0
    December $0 $0
    Total $14,000 $3,500

    Total Potential Match would have been $6,000 so I would miss out on $2,500 in matching money.

    By Blogger 2million, at 9:39 AM  

  • 2million - I work for IBM as well. One number I don't see is the actual percent you contribute each month in this scenario. What percentage are you using that hits the $15K limit in 2006 during October? 18% of each paycheck?

    Also IBM has an internal tool that may help with the calculation:

    http://w3-1.ibm.com/hr/us/tdsp/tdspopt.shtml

    By Anonymous Anonymous, at 9:53 AM  

  • 2 mil,

    "Not in the 401k plan I currently participate in. In your example of $2000 in monthly contributions (with $14k contibution limit) I would max out and get something like this:
    Month Contribution Match
    January $2,000 $500..."

    Maybe I'm confused here, but does your company match salary, or contributions? I'm used to seeing contributions matched, not salary. If it is contributions, the match is 120, not 500.

    By Anonymous Anonymous, at 11:47 AM  

  • I left a comment in another post of yours. I didn't make contribution from my first paycheck but catch up the limit in the last month. In 2005, just like you said, I only got the "match" from 6% of per paycheck. However, I found that I got some extra contribution to my 401k on 01/10/2006, which was recorded as employee match. The amount seems to be the match what I though I have lost in my first pay check of last year. By the way, I also work in IBM. Did you receive any extra contribution in Jan 10th,2006?
    But my situation is a little different from your example. Yours was to maximize the annual limit earlier. But mine was to catch up in the year end.

    By Blogger circle, at 5:58 PM  

  • Take a look at: http://www.401kprofessionals.com

    Companies (plan sponsors) need to make sure they are benchmarking their 401(k) plan vs. the market. Fees and services change with time. You also have to make sure the funds you originally selected are still doing well. Who is doing the on-going due dilligence on the funds? It's a good question to ask. You also need to make sure you are ERISA 404(c) compliant.

    By Anonymous Anonymous, at 7:54 PM  

  • The IBM 401K plan is changing so that you will get the full match for your base pay (as long as you pay in at least 6%) regardless of when you hit the limit. Not sure when this change takes effect, probably 2008 along with the other changes.

    By Anonymous Anonymous, at 11:48 AM  

  • 3000$ in matchup contributions is damn good! and if you have something lke that for a few years, you oculd have a large nest egg over 7 years.

    http://www.research401k.com/401k-longterm-growth.html

    A study carried out by 2 Washington DC state organizations revealed that 401k participants who contributed payments towards their employer sponsored 401k retirement plans over the past 7 years have seen growth rates of over 50%. This is inspite of the tech boom bust of 2000 and market declines in 2002. Here is some data published by the Employee Benefit Research Institute and the Investment Company Institute (EBRI):

    personally i'm at the $50k level, and sticking with my 401k over the longer term

    By Blogger Sadhra, at 4:45 PM  

  • I realize I'm a bit late on this one, but I figured for those coming in off a search could use some updated information.

    First, 401(k) contribution limits are explained quite nicely here: Fidelity: Contribution Limits, which spells out how $15000 is the pre-tax contribution limit, but $45000 is the total contribution limit, including matching and after-tax. This limits the amount of non-salary compensation companies can sneak to their executives.

    As far as IBM is concerned, for 2006 there was a "match maximizer" which made up the missed contributions in January of the next year (which raises the question of which year's $45,000 limit this contributes toward). That was discontinued at the end of 2006, but the 401(k) benefits site still has wording to the same effect.

    The other question on that one is concerning new-hires. If a person was hired in September of 2006, say, and needs one year of service to be eligible for matching, then how smart is the make-up calculation? If they max out their 401(k) before September, will it still recognize that they should be matched for Sept-Dec? Or will it overcompensate for 6% of all of 2007?

    By Anonymous Mark, at 12:47 AM  

  • For the IBM employees who posted here: the rules have changed in favor of the employee as of 2006. The company checks at the end of the year if you missed out on company-matched dollars and makes up the difference. I know it works because I accidentally hit the limit too soon and they made up for it in January.

    Think other companies should do the same.

    By Anonymous Anonymous, at 12:14 PM  

  • I max out my 401k about Auguest or Sept of each year. My company does not contribute their matching postion after I hit the limit but then in early January of the following year, they lump in the reamining matching postion that was due to me after I reached the limited. Maybe this happens to others as well?

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