Maximize Your Retirement Plan Contributions

The last several years have brought about an array of alternatives for people to consider when saving for retirement. Some of the more common types of plans include traditional Individual Retirement Accounts (IRAs), Roth IRAs, 457 Plans, 403(b) Plans, Simplified Employee Pensions (SEPs), and, of course, 401(k) Plans.

Regardless of which plan is best (or available), there are some things that everyone should consider before funding their retirement plan. Individuals should consider their choices now. A new year is about to start and most plans allow for new elections at the beginning of the year. Waiting too long may hinder effective retirement planning. 


One planning technique is to make sure you take advantage of dollar cost averaging. Dollar cost averaging is an investing technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the current share price. Dollar cost averaging allows you to buy more shares when the price per share is low and fewer shares when the price is higher. Dollar cost averaging lessens the risk of making a large investment when the investment is at a high point.


Assume the per share price of XYZ Inc. is $15 on January 1, $12 on April 1, $10 on July 1, and $15 on October 1. If you invest $15,000 of XYZ stock on January 1 you will have bought 1,000 shares and the value of your holdings would be $15,000 at the end of the year (ignoring dividends, etc.). Contrast this with someone who instead invested $3,750 on the first day of each calendar quarter. That investor would have 1,187.5 shares, or over 18% more shares. The total amount invested is the same $15,000, but the second person had a far greater return.

[The investor who bought all $15,000 early in the year would, of course, wind up being better off if the share price went up throughout the year. The point, however, is that dollar cost averaging reduces the risk of buying when a stock is at its high point.]

This technique is often overlooked when self-employed people make contributions to their retirement plan (e.g., Keogh Plans, SEPs, etc.). Oftentimes their accountant will simply advise them that the maximum they can deduct is, say, $46,000 and the investment must be made by the due date of the tax return. Many clients will invest the $46,000 on April 15. A better way might be to extend the due date for filing the tax return to October 15 and invest $7,667 each month for the next 6 months (or a greater amount over fewer months if you file the return before October 15). An even better alternative might be for the self-employed person to invest, say, $2,000 each month during the tax year and have catch up contributions amounting to $22,000 after the end of the tax year (from January 1 through the extended due date of the return).


A second technique is best suited for people whose employer matches an employee's contribution to the retirement plan. Although many 401(k) plans have this feature, there could be any of several variations in employer matching. One common arrangement is where employees can invest up to 15% of their salary in the employer's 401(k) plan (up to the statutory limit) and the employer will match half of the first 5% the employee contributes. An employee who fully funds his plan as early as possible may not be taking advantage of the employer's matching provision.


Assume an employee elects to contribute $16,500 to her employer's 401(k) plan for tax year 2010 and the employer's plan has a matching provision as described in the preceding paragraph. Further assume that the employee's salary is $330,000/year.

If the employee contributes as much as she can as early in the year as possible, she will have "maxed out" on her $16,500 contribution in April. That is, she will have contributed $4,125 from each of her paychecks in January through April; the employer will have made matching contributions totaling $2,750.

Had the employee in this example contributed 5% of her salary to the 401(k) plan (instead of 15%), she still would have contributed $16,500 over the course of the year, but her employer would have made matching contributions totaling $8,250, or an additional $5,500.

[Click here for a comprehensive example of the arithmetic discussed above.] 

An additional benefit to spreading out the contribution would be take advantage of dollar cost averaging (discussed above). Two possible downsides come to mind for the employee who takes this approach. One would be tax-free deferral in the 401(k) plan over a shorter period. However, the greater overall amount being deferred should more than make up for this. The second downside could apply in situations where the employee is contemplating a change of jobs and the new employer has a waiting period before employees can participate in its 401(k) plan. For example, if the employee starts work at a new employer in April and the new employer has a one-year waiting period before employees can participate in its 401(k) plans, the employee may not be able to fund her retirement plan with $16,500 for the year. Though this could apply, a more common waiting period is 6 months and the employee would likely still reap greater benefits by electing the smaller deferral.


There are many tax and investment planning strategies that should be considered sooner rather than later. And don't forget - self employed persons hoping to take a tax deduction for a contribution to a Keogh plan must open the plan before the start of the new year. It can be funded later, but the plan must have been opened by December 31.

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