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The Short Answer

How Saving Too Much in Your 401(k) Could Cost You

Company matches are typically allotted each pay period, meaning those who max out annual contributions early could miss out on extra retirement savings.

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Note: This article is part of Morningstar's February 2014 Tax Relief Week special report. An earlier version of this article appeared Jan. 27.

Question: A friend says he missed out on part of his employer's 401(k) matching contribution because he contributed too much to the plan. How is this possible?

Answer: The idea of contributing too much to a company retirement plan may sound strange, but it can happen, especially if an employee contributes high amounts in a short time frame, thereby missing out on part of the employer's 401(k) match, rather than spreading contributions out during the year.

Many companies match a portion of their employees' 401(k) contributions each pay period as an incentive for their workers to save for retirement. So if a company offers a dollar-for-dollar match on the first 3% of pay, that means an employee who contributes 5% of pay to the plan ends up receiving a total contribution of 8% of pay when the company match is factored in. But what if the employee is a super saver and contributes quite a bit more--say, 25% of pay each pay period? That's where he or she can run into trouble by hitting the annual contribution limit too early in the year and thus missing out on further matching contributions.

Saving Too Much Too Soon
For 2014 the annual 401(k) contribution limit for workers under age 50 is $17,500, and for those age 50 and older it's $23,000. (Matching contributions from the employer don't count toward these caps.) Let's say a 40-year-old worker who makes $100,000 a year contributes 25% of her pay to a 401(k) plan every two weeks starting in January, and that the company matches the first 3% dollar-for-dollar. By contributing at such a high rate, the worker would reach the $17,500 cap on annual contributions sometime in September and wouldn't be able to make any more contributions after that. 

Up to that point the worker would have had $2,192 added to her 401(k) through her employer match. But by contributing at a lower rate each pay period (17.5% of pay to be exact) and spreading her contributions out more evenly throughout the full calendar year, the worker would receive a full year's worth of the employer match: $3,000. By contributing too much too soon, the worker has cost herself more than $800 in free retirement money from her employer.

Some Plan Designs Avoid the Problem
The above scenario holds true for employers who match 401(k) contributions on a per-pay-period basis. However, some employers offer what's known as a "true-up" provision in their plans, which means the plan calculates the potential maximum match the employee could have received based on the amount he or she contributed during the year and then fills in any gap. For example, in the scenario we've just described, the company 401(k) plan would provide a one-time contribution of $808 to cover the match that the employee missed out on by hitting the contribution limit too quickly. 

The true-up method also may help an employee who contributes too little to get the full company match in some pay periods but more than enough to get it in others to receive the maximum possible match based on his or her total annual 401(k) contribution. If you're not sure whether your company offers a true-up provision and you're worried you will hit the 401(k) contribution limit before the end of the year, ask your benefits department or consult the plan document, as this could affect your decision on whether to save more earlier in the year.

Beware the Bonus
Another factor that could cause some employees to reach the 401(k) annual contribution limit earlier than scheduled is their employee bonus. An employee who receives a bigger bonus than expected (lucky you!) and redirects a portion of that bonus to the company retirement plan could unwittingly end up hitting the annual contribution limit sooner than expected. Unless your plan includes a true-up provision, it's a good idea to calculate whether you're likely to reach the contribution limit before year's end and potentially miss out on the full employer match. Plans typically allow employees to change their contribution amounts during the year, so an employee contributing part of a bonus to his or her company-sponsored retirement plan can adjust future contributions accordingly.

Also worth noting is that some companies match workers' 401(k) contributions in a lump sum once a year.  International Business Machines (IBM) made headlines at the end of 2012 when it announced it would switch to a system in which the company pays out matching contributions in a lump sum at year's end, a move seen by some as a way to entice workers not to leave the company earlier in the year. Just this month AOL (AOL) said it was planning a similar move but reversed course after employees complained. About 8% of U.S. companies pay out retirement-plan matching contributions as a lump sum, according to a 2013 survey by Aon Hewitt. As with plans with a true-up provision, the timing of contributions in these cases is less important than the amount contributed as far as the match goes.

For workers whose employers continue to match their 401(k) contributions on a per-paycheck basis, it's well worth planning ahead so as not to miss out on matches later in the year. Saving a lot in your 401(k) is a good thing, but when you save it may be nearly as important. MIC 2014 Ad Module

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Adam Zoll does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.