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Should you max out your 401(k) early in the year?

US News & World Report -  Money logo US News & World Report - Money 1/13/2018 Rebecca Lake

Video by Kiplinger

The typical employee contributed 8.5 percent of his salary to a 401(k) in the third quarter of 2017, according to Fidelity Investments – the highest rate in almost a decade. Twenty-nine percent of savers reported upping their contribution rate over the previous year.

While investors are saving more in their plans, only a small number are taking full advantage of their 401(k)'s potential. Vanguard's 2017 report "How America Saves" found that just 10 percent of investors contributed the full $18,000 allowed to their plans in 2016.

See: 7 Things That Can Derail Your Retirement Investing

If one of your investing resolutions for 2018 is to max out your retirement account, how quickly you do it matters. There are two paths available: Front-load your contributions early in the year or spread them out evenly. So which makes more sense?

"The long and short of it is, it all depends," says Rob Kolb, partner at Go Green Financial & Insurance Services in Rocklin, California.

Traditionally, the standard practice has been dollar-cost averaging, a strategy built on the premise that contributing monthly and consistently over a long period will reap steadier returns by averaging the ups and downs of the market.

Investors, though, don't always have the ability or opportunity to use time and consistency to their advantage, Kolb says. In that case, front-loading contributions to a 401(k) may be the better choice, but before maxing out your plan early, here's what else you should consider.

The stage the market cycle is in. Where we currently are in a market cycle can help you decide whether to front-load 401(k) contributions. "If the market is growing, you can benefit even more by front-loading, as the funds will be in your account for a longer period, as opposed to making steady monthly contributions over the year," says Tamra Stern, partner and director of wealth management for Main Street Research in Sausalito, California.

Although spreading your contributions evenly throughout the year can make your portfolio less volatile, it could also result in lower returns, says Paul Jacobs, certified financial planner and chief investment officer at Palisades Hudson Financial Group's Atlanta office. "When markets are going up, you'll miss out on some appreciation, but when markets are falling, your performance will be better as you buy at lower prices." Because the market is unpredictable, one strategy may work better than the other some years.

As you evaluate the market, consider what your appetite is for risk. "Maxing out your 401(k) early in the year sounds a lot like trying to time the market, and that's a risky endeavor that burns even professional investors," says Anna-Louise Jackson, investing specialist with personal finance website NerdWallet. True, your returns may be better in a year when the market ends higher, and your money has more time to benefit from compounding interest.

The disadvantages can far outweigh the advantages, however. "You could miscalculate how much money you'll need to make ends meet and rack up debt, or if the market peaks in the first part of the year only to fall in subsequent months, you'll have bought in at the highs," Jackson says. "As boring as it may be, consistency begets success in the stock market."

Your career trajectory. Careers can get interrupted, by school or other obligations, before eventually ending in retirement. Where you are along that trajectory will determine whether front-loading is advantageous or more trouble than it's worth.

For instance, "it might make sense to make your full contribution if you're about to retire," says Lonny Powell, founder and president of Alliance Retirement Solutions in Louisville, Kentucky. "You should also consider front-loading if you're switching jobs and your new employer doesn't offer a comparable match, or if you're transitioning to a job that doesn't offer a 401(k) plan."

Jackson says that if you plan to go back to school and reduce your work hours, or take an extended leave of absence, "you'll be well-served by setting aside any extra money you can now for retirement." Still, she adds, these scenarios are exceptions, rather than the rule.

For most people, the twists and turns of a career path are more often marked by a change of job. If you're planning to switch jobs, maxing out your plan may offer less of a payoff than if you rolled over your savings into your new employer's 401(k). The vesting rules for employer matching contributions are also a factor, Jacobs says. "If you leave your job before the matching contributions vest, you only get to keep your personal contributions."

Your employer's matching contribution. According to Deloitte's 2017 Defined Contribution Benchmarking Survey, 93 percent of plan sponsors offer some form of match to employees. Maxing out your 401(k) early in the year, however, could compromise your ability to cash in on the match.

Stern says some plans only offer matching contributions during pay periods when you're actually contributing to the plan. Front-loading your 401(k) could mean missing out on free money when you're not making contributions.

Here's an example. If you make $200,000 per year, you'd need to contribute just over 9 percent of your salary each month to hit the annual $18,500 contribution limit for 2018. Assuming your employer matches 6 percent of your salary, your match would total $12,000. If you increase your contributions to 18.5 percent, you will max out the plan halfway through the year, cutting your $12,000 employer's match in half. "Some plans will offer a makeup contribution in case front-loading causes you to miss out on some of the match; however, these makeup contributions typically don't come until late the following year," Stern says. While some additional match is better than none, you may gain more by distributing your contributions evenly.

The point, however, may be moot if your employer's plan offers a relatively small match or none at all. If so, you could front-load your plan, and then look to other tax-advantaged savings options. Kolb suggests a Roth individual retirement account. "Your investments grow tax-free, and because your contributions are made with post-tax dollars, you'll avoid being taxed on withdrawals at retirement." For 2018, IRA contribution limits remain unchanged at $5,500, and $6,500 for those age 50 and older.

Whether you front-load or not, starting early and saving regularly are the keys to a successful retirement, Kolb says. "Nothing helps more than having time on your side."

Copyright 2017 U.S. News & World Report


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