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The start of every fire begins with a source of ignition.
So what better way is there to talk about igniting your own journey to FIRE, the financial independence/retire early kind, than to talk about a match?
I am not talking about any old match you find in your kitchen drawer.
No. This match is far more powerful and packs a much larger financial punch.
Of course I am talking about, for those lucky enough to have it, your company 401k match.
A Brief History of the 401k.
The history of the 401k is quite interesting as it was a side effect of a Congressional mandate passed, the Revenue Act of 1978.
Prior to the implementation of the 401k, employers typically rewarded their employees with pensions after years of service.
However these pension/defined benefit plans were expensive for businesses to maintain.
The responsibility and corresponding liabilities for making necessary investments to meet these benefits fell on the shoulders of the company and its pension plan administrators.
Therefore with the birth of the 401k, businesses astutely figured out that it would be in their best interest to shift this burden from the company books and push it onto the employee’s shoulders instead.
Pensions have therefore become increasingly rare as its replacement, the 401k, took over as the best retirement vehicle available to workers.
The Company Match.
Most employers offer a company match so that they can attract quality workers and encourage retirement saving practices.
It varies between companies but typically a company will match a percentage of an employee’s own retirement contribution up to a certain defined amount.
It is important also to pay attention to see if there is a tiered system in place for your company match.
For example a common company match structure is:
- 100% match up to a certain percentage of your pay contributed.
- 50% match of any pay contribution for the next couple of percentage points.
Myth: Company match money is free money.
Most individuals incorrectly assume that the employee 401k match is “free money.”
Unfortunately nothing in life is truly free.
Companies that offer a match have already factored that into their employee compensation packages when they are hiring.
The money you receive “free” in a match can be considered as money that would have instead gone towards your salary if there was no company match offered.
Company bean counters only have one financial pie to carve from.
If you give more in one slice (i.e. the match) there is likely a corresponding decrease in another slice (your salary).
Of course if you choose not to partake in the match the company truly comes out ahead, as you are working at this lower offered salary AND the company is relieved of its financial duty towards the stated company match.
It may be in your best interest to go for the lower company match level.
This seems quite counter-intuitive but let me explain.
There are certain scenarios where the highest company match tier may not be in your best interest.
I will use my own company match structure as an example:
In my place of employment the 401k match is the following:
- Tier 1: 100% match of the first 3% of my pay I contribute.
- Tier 2: 50% match of the next 2% of my pay I contribute.
- Tier 3: Anything above 5% of pay contribution level does not qualify for additional company match dollars.
So the highest level of company match based on this formula is 4% (achieved if a 5% of pay contribution level is designated).
Four percent is better than three percent, right?
So it would be a no-brainer to put in a request to contribute 5% from my payroll and achieve the maximum company percentage match, wouldn’t it?
Not so fast.
There exists a situation where you could actually be leaving money on the table if you went with this higher tier of the company match.
Helpful background information.
Before we dive into the math portion of this post, I wanted to give some background to let everyone be on the same page.
For 2019, the IRS contribution limits for a 401k plan is $19k if you are younger than 50.
If you are 50 or older, you are allowed a “catch up” with an additional allowable contribution of $6k (total contribution of $25k).
[This $6k additional money typically does not have any bearing on employer match calculations and therefore not a factor in the subsequent scenarios described below.]
The employee compensation limit for calculating contributions is $280k (even if you make more than this, in the eyes of the IRS for contributions you will be treated as if you made $280k).
Using this information, the maximum match I could expect from my employer would therefore be $11.2k ($280k x 0.04=$11.2k).
When the 3% company match is better for you than a 4% match.
As there is only so much protected tax-deferred space available ($19k) because of the IRS limits, you have to maximize the match by gaming the system with your contribution schedule.
You essentially want each dollar to give you the best bang for the buck.
At the 3% level of pay contribution (tier 1), every dollar you contribute brings with it a corresponding company match dollar (1:1 ratio).
Any contribution above this first tier level and you will encounter diminishing returns with regards to match money.
At the 5% level, every $5 you contribute only brings 4 of those valuable company match dollars along with it.
There are many individuals who like to front load their tax deferred contributions, but this approach can actually backfire on them.
I will use an extreme example with hypothetical numbers to make the math easier:
Dr. Front Loader is able to hit her $19k contribution limit during the first pay period of the year by choosing a 100% deferment.
Instead of getting the full $11.2k company match she would be entitled to if she stayed at the 3% Tier 1 level, she now finds her self only receiving $760 of the company match (4% of $19k) and being short changed by $10,440.
Some companies do offer what’s called a “true-up” which means at the end of the business fiscal year (following March) they will add the match dollars you may have missed out by deferring at the tier 2 or 3 levels.
This, however, is not always the case.
It is therefore wise to first check with your HR department to see if the company does indeed offer a true up or not to see if front-loading would end up financially penalizing you.
So based on the above numbers, you would be right to conclude that deferring 3% of your pay is the way to go to guarantee maximizing your company match.
Unfortunately there is one fairly large hurdle that still needs to be overcome to make the whole scenario work.
That hurdle is the income threshold needed for the above numbers to play out.
You see, in order to get $19k contributed by the end of the year at the 3% contribution, you need to have at least a salary of $633k ($633k x 0.03=$19k
Any income lower than this automatically forces you to have a higher deferral rate in order to hit the $19k threshold.
So what should I do if I am like the vast majority and don’t make $633k+/yr and my company does not do a “true up?”
If your salary does not meet this income threshold then it is still financially a better move to contribute at the next tier level (level 2), as a diminished match return is still better than no match at all.
The best way to ensure you are still getting the most match money is first determining your contribution goal, $19k in this case, and dividing that by your expected annual salary.
The resulting percentage you obtain should be the maximum amount you elect to defer if you want to spread out your contributions over the entire year, maximize your match dollars, and hit your goal of deferring $19k.
In my example, any salary lower than $380k/year would require you to contribute more than 5% (and thus force you into the undesirable match Tier 3 level) to hit the $19k limit.
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Even a steadfast DIY’er can sometimes gain benefit from the occasional professional input.
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