The other day, a coworker asked me if making a lump sum contribution to a 401(k) with the market depressed in the midst of COVID-19 would be a good idea. In essence, he was looking to time the market, buying when things looked low.
I reminded him that “time in the market is more important than timing the market.”
But his question reminded me of something that I started years ago: front-loading my 401(k) contributions, a practice I started after learning it from the Mad Fientist.
What is Front-Loading?
Front-loading is setting a really high contribution percentage and exhausting the 401(k) contribution in the first few months of the year. The IRS limits how much I can contribute to my 401(k) each year ($19,500 in 2020) but there’s no restriction on when the contribution is made. My employer won’t advance my salary, so my contributions are limited to my paycheck, minus FICA taxes and other paycheck deductions.
As an example, take a hypothetical annual salary of $78k with weekly paychecks of $1,500. If I bumped my contribution rate to 80% (or $1,200 per pay period), my annual limit would be exhausted in just over 16 weeks, or the end of April. Then, from April through December, my company would no longer withdraw any 401(k) contributions until the next January.
But what about dollar cost averaging?
By regularly contributing to my 401(k) each pay period, sometimes my contribution is when the market is high (bad), and sometimes when it’s low (good), but most of the time somewhere in between. The central idea of dollar cost averaging is that it all averages out over time.
Front-loading partially breaks dollar cost averaging within a given year, but preserves it across the years. And unless I make a 100% contribution on the first pay period of January, I still get some dollar cost averaging across some of my pay periods.
But dollar cost averaging itself is a form of market timing: spreading investments out in the fear that right now might be too high. Research by Vanguard suggests that 2/3rds of the time, investing a lump sum of money all at once beats spreading it out over time.
Once again, time in the market is more important than timing the market.
The Cash Flow Challenge
Because I front-load my contributions, my paychecks in the early part of the year are drastically smaller than later. I need reserves to weather it.
For someone wanting to front-load, this could be a challenge. Possible solutions include increasing one’s savings in the year before front-loading starts to prepare for it. Another option is relying on one’s emergency savings, with the obvious risk of losing one’s job during the first part of the year. I’m sure there are more options.
Other Things to Consider
Employers sometimes limit the percentage of your salary you can contribute, making it harder to front-load. A previous employer limited contribution rates at 50%. My current one limits me to 100%, but I suspect that’s after all the benefit premiums and taxes are covered.
Employer matches (I currently don’t get one) are another challenge. Employers may continue to spread their match out over the year even if you exhaust your contribution earlier in the year. Or they may not. Check with your HR.
To dig deeper on the match question, one thing I worry about is about switching employers mid-year. I currently don’t get a match and if I exhaust my 401(k) contributions with my current employer and then switch to an employer that does offer a match, I won’t be able to get that match until the following year when I can start contributing again. Bummer.
On the other hand, if I do lose my job, front-loading reduces the risk that I won’t be able to contribute my maximum for the year, losing a portion of the tax advantage from my 401(k). Of course, getting the max contribution might be at the bottom of my list of things to worry about right then.
Another thing to consider is the impact of 401(k) administration fees. My current 401(k) provider charges me .70%. By front-loading, I expose more of my annual contribution to the fee for a longer period of time.
There’s probably a thousand other things I’m forgetting to consider.
Show me the Numbers
So how does it hold up over time? How about an example. To make things easy, in the example all contributions go into an index fund, VTSAX. The contribution limit is exhausted by March 31st of each year. And the 401(k) plan fee is .70%. Taking the adjusted closing price of VTSAX over the past ten years, the 401(k) value is $10k more than the no front-loading case. That’s bigger by 3.12%.
Here’s a graph of the scenario:
I calculated other scenarios where the front-loading is both more extreme and less extreme, but I’ll save that for a future post.
I’ve been pleased with my experiment of front-loading my 401(k) contributions. Every little bit of return boosting helps.
Have you tried front-loading? I’d love to hear about it in the comments below.