I love ice cream. As a kid, I could literally polish off a 1/2 gallon of Mayfield’s chocolate ice cream in one sitting and somehow still feel cheated. While age and a slowing metabolism put an end to that indulgence, I still enjoy the family outings to our local ice cream shop. During a recent outing, I watched my 4 year old daughter shovel heaping spoonfuls of her frozen chocolate treat into her mouth until she threw her hands over her head and yelled out, “Aargh, brain freeze!”
Looking back on this experience got me thinking about how Life has a funny way of teaching us lessons. This outing taught my daughter (and reminded me) that it’s possible to have too much of a good thing. Naturally, as any good financial planner would do, I wondered how I could apply this lesson to a financial experience.
I started to think, and my mind drifted to retirement and to the opportunities that help us achieve this goal. Take, for example, saving for retirement in your company retirement plan, such as a 401(k) or the Thrift Savings Plan. An employer retirement plan is a terrific savings vehicle, and provides us an opportunity to save money on a tax-advantaged basis, but like so many good things in life, it too can be overdone. Let me explain.
If you’re lucky enough to work for an employer who matches your contributions, you’ll have several potential sources of contributions to your employer’s retirement plan. The first is your salary deferral, which is the amount you ask your employer to deduct from your pay to contribute on your behalf to your retirement plan. There is a limit on salary deferrals, which is $18,000 for 2017 and $18,500 for 2018. The second source, catch-up contributions, are available to those over the age of 50 and are also subject to an annual limit, which is $6,000 for 2017 and 2018.
A third source, the employer matching contribution, is based on the amount of the salary deferral contribution you make each pay period. A typical employer matching arrangement may be a dollar-for-dollar matching contribution on the first 3 percent of pay you contribute, and then 50 cents on the dollar for the next 2 percent of pay you contribute (if you’re a federal employee participating in the Federal Employees Retirement System, this should sound familiar). So, if you contribute 3 percent of pay, your employer matching contribution will be 3 percent of pay. If you contribute 5 percent of pay, your employer matching contribution will total 4 percent of pay.
Considering this is a guaranteed 80 percent return on your investment, you’ll want to contribute at least enough (5 percent of your pay in this example) to maximize the value of your employer matching contributions. However, as I alluded to earlier, it’s possible to overindulge, and those in the position to save the annual limit need to be careful they don’t miss out on the full employer matching contribution.
Remember, the employer matching contributions are based on your salary deferrals, and if you do not make a salary deferral, you will not receive an employer matching contribution. Consider the scenario where an employee contributes so much of his or her pay that the annual limit on salary deferrals is reached prior to year-end. In this situation, the employer matching contribution will also stop prior to year-end, and the employee will receive less than the full potential.
For example, let’s look at a case where an employee with a $100,000 salary sets her salary deferrals at 25 percent of pay. Assuming 26 pay periods in the year, her employer matching contribution will be $153.85 per pay period. Although she has the potential to receive $4,000 in employer matching contributions, she’ll only receive $2,923. This is because she will reach the $18,000 annual limit on salary deferrals in only 19 pay periods and miss out on employer matching contribution for the remaining 7 pay periods.
Although it may feel gratifying to knock out your annual salary deferrals as quickly as possible, you may actually be doing yourself financial harm if you hit the annual limit too early. Instead, space out your elective deferrals over the entire year and you’ll maximize the employer matching contributions each year.
When you retire, you can then use that extra money to treat your grandkids to ice cream. Aargh, brain freeze!