This article was last updated on March 24
Every year around November when the IRS publishes updated 401k plan limits for the year ahead I set myself a goal to see how fast I can reach the maximum contribution limit. I am fortunate that I earn and save enough money to make the maximum pre-tax retirement account contributions, but even if you cannot get to the maximum limit these 5 reasons to try and maximize your contributions still apply:
Forced Saving. Following the holidays and into the New Year we have probably spent more than we wanted to and even dipped into our (after tax) savings. So I normally set my normal “financial” clock to start in February, as January is a month of catching up and taking care of bills. So following the glut of holiday spending and financial guilt, I force myself to contribute 25% of my pre-tax income towards my 401k retirement account, until I hit the limit. For someone making $100,000 this would be approximately $960 per fortnight. At this rate you would hit the $18,000 annual limit (for this year) sometime in October. The more you make and contribute the faster you get there. Some years I even set my limit at 35% – but this means strict budgeting and cutting back in lots of other areas.
Investment Options. I normally just allocate my 401k funds across low cost index funds. I have used Vanguard and Fidelity at different employers, but essentially I split my index fund allocation to try and 60% in US funds, 30% international funds and 10% bonds or money market funds. The older you are the more you may want in bonds or money market funds. For those who say that by contributing early I may end up putting money in at the top of market, then I say put some of your savings into cash (or in a money market fund). You can then choose to invest as and when you need, though for most investors market timing rarely works over the long run. I prefer dollar cost averaging as it is less hassle and for every peak I invest at I will also get opportunities to buy on dips.
Tax benefits and Employer matching. By contributing to my retirement account aggressively early on I reap the tax benefits on capital gains immediately (in that no taxes on any gains!). I also get the employer match much earlier so a good start to the market (first half of a year stock market performance has historically been better than later halves – google it) boosts my returns on investment. Again per the above point if you feel the market is headed down then leave your money in a cash fund and invest as needed. The key is you are saving for the longer term.
More disposable income at year end. Once I hit may 401k max, I get a nice bump in my weekly after tax payment. By this point I have gotten used to the lower take home pay (with my higher 401k contributions) so this extra bump is nice and I can use it for upcoming holiday spending. See the virtuous cycle? Forced savings ends up providing extra longer term spending capability.
IRA boost. The other good thing about maxing out your 401k early is you can super charge your retirement savings by contributing to an IRA or even Roth IRA. Since you are already in the habit of putting away 25%, why not just keep it going. The IRA contributions are lower than 401k limits and are subject to income limits. But even if you make too much that precludes you from contributing a Roth IRA or to claim your traditional IRA deductions as a tax deduction, you can still make non-deductible contributions where the gains go tax free until retirement.
So there you have it, my rationale for maxing out 401k contributions as early as possible with the 25% rule. I know this is not going to be feasible for a lot of people, but hopefully the concept of putting away as much as you can as fast you can, will be taken to heed when it comes to your retirement planning.