2875: Should You Max Out Your 401(k) Earlier in the Year? by Nick Maggiulli of Of Dollars and Data on Retirement Investing

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[00:00:39] [SPEAKER_00]: This is Optimal Finance Daily. Should you max out your 401k earlier in the year by Nick Maggiulli

[00:00:47] [SPEAKER_00]: of Of Dollars and Data dot com. And I'm your host and personal finance enthusiast, Diana Merriam.

[00:00:55] [SPEAKER_00]: I'm going to jump right into our next post as we optimize your life. Should you max out your 401k

[00:01:06] [SPEAKER_00]: earlier in the year by Nick Maggiulli of Of Dollars and Data dot com.

[00:01:12] [SPEAKER_00]: One of the most common questions I get asked by readers is, should I max out my 401k earlier in

[00:01:20] [SPEAKER_00]: the year or just contribute normally to max it out by year end? Though I'm not the biggest fan

[00:01:27] [SPEAKER_00]: of maxing out your 401k, especially for young aggressive savers. There's some evidence that

[00:01:34] [SPEAKER_00]: maxing out earlier in the year can provide some benefit over maxing out by year end.

[00:01:40] [SPEAKER_00]: Why is this true? Because markets tend to go up. And since markets tend to go up,

[00:01:46] [SPEAKER_00]: there's a slight advantage to getting your money into the market sooner rather than later.

[00:01:52] [SPEAKER_00]: Of course, over a one year period, the difference between doing all of your contributions in

[00:01:58] [SPEAKER_00]: January, max early, and doing contributions throughout the year, average in, will be

[00:02:05] [SPEAKER_00]: quite small, even when investing in a 100% US stock portfolio. In fact, since 1978,

[00:02:14] [SPEAKER_00]: when the 401k was first introduced, the biggest difference between maxing early and averaging in

[00:02:21] [SPEAKER_00]: to a 100% US stock portfolio over one year was about 13 to 15%. This means that for a $20,000

[00:02:32] [SPEAKER_00]: contribution, choosing one strategy over the other could have netted you as much as $2,000 to $3,000.

[00:02:39] [SPEAKER_00]: But that's only in the most extreme years. Typically, the amount of outperformance you

[00:02:46] [SPEAKER_00]: get by following one of these strategies for a year is under $1,000 or about 5% of total

[00:02:53] [SPEAKER_00]: contributions. If you were to look at the distribution of how much max early outperforms

[00:03:00] [SPEAKER_00]: average in over each one year period since 1978, you could see more clearly that this distribution

[00:03:08] [SPEAKER_00]: is somewhat symmetrical, meaning that in some years max early outperforms and in some years

[00:03:15] [SPEAKER_00]: average in outperforms. Max early had a slight edge over average in across all one year periods

[00:03:23] [SPEAKER_00]: since 1978. To be more precise, the max early strategy outperforms by $700 in a typical year.

[00:03:33] [SPEAKER_00]: Long story short, if you're deciding whether to max out your 401k early for just one year,

[00:03:39] [SPEAKER_00]: it doesn't really matter what you do. Yes, statistically maxing early should provide a

[00:03:44] [SPEAKER_00]: slight advantage, but that advantage isn't all that big in the grand scheme of things.

[00:03:51] [SPEAKER_00]: So when does maxing your 401k earlier in the year actually matter? When does maxing out your 401k

[00:03:59] [SPEAKER_00]: early actually matter? Maxing out your 401k earlier in the year can make a bigger difference

[00:04:06] [SPEAKER_00]: if you do it for multiple years in a row. Though one year won't make a difference to your financial

[00:04:12] [SPEAKER_00]: plan, the data suggests that doing this for many years can have a sizable impact. For example,

[00:04:20] [SPEAKER_00]: imagine we compare the max early strategy and the average in strategy for 10 years in a row.

[00:04:27] [SPEAKER_00]: So each year for 10 years, max early would contribute $20,000 in January while average

[00:04:35] [SPEAKER_00]: in contributed $1,667 each month for 12 months. After running the simulation and comparing the

[00:04:45] [SPEAKER_00]: performance between these two strategies for each 10-year period since 1978, there is a clear winner.

[00:04:53] [SPEAKER_00]: Over a 10-year timeframe, max early really pays off. In absolute terms, the typical performance

[00:05:00] [SPEAKER_00]: difference is $11,500 in favor of max early or about 4-5% of total contributions. In the grand

[00:05:11] [SPEAKER_00]: scheme of things, this still isn't a ton of money, but it's not negligible either. After examining

[00:05:18] [SPEAKER_00]: both the 10-year simulations and the one-year simulations, a pattern emerges. The typical

[00:05:26] [SPEAKER_00]: outperformance of max early over average in is about 5% of total contributions. This is a rough

[00:05:34] [SPEAKER_00]: approximation of what you should expect if you follow this strategy for any number of years.

[00:05:40] [SPEAKER_00]: So if you were to max out your 401k earlier in the year for 20 years at an annual contribution

[00:05:47] [SPEAKER_00]: of $20,000, you should expect to have about 5% more than if you didn't max early. On $400,000

[00:05:56] [SPEAKER_00]: in contributions over 20 years, that means an extra $20,000. I ran the numbers as a sanity

[00:06:03] [SPEAKER_00]: check and the median outperformance of max early for every 20-year period since 1978 was $22,000,

[00:06:12] [SPEAKER_00]: a little above 5% of total contributions. While it's nice that the empirical evidence

[00:06:19] [SPEAKER_00]: matches the theory, we haven't addressed the elephant in the room. Is this strategy even

[00:06:25] [SPEAKER_00]: feasible? Is maxing out your 401k earlier in the year feasible? While maxing out your 401k

[00:06:33] [SPEAKER_00]: earlier in the year could provide you with some benefit, the number of households that could do

[00:06:39] [SPEAKER_00]: this with ease is quite small. Why? Because to max out your 401k in the first month of the year

[00:06:46] [SPEAKER_00]: would require $20,500 in contributions over two paychecks. That means that this strategy is

[00:06:54] [SPEAKER_00]: limited to someone making at least $240,000 a year. Of course, if you make less than this,

[00:07:01] [SPEAKER_00]: you could still max out over the first two to three months of the year, but the benefit would

[00:07:07] [SPEAKER_00]: be smaller than the 5% from earlier. Nevertheless, just because this strategy isn't feasible for

[00:07:14] [SPEAKER_00]: most people with a 401k, this doesn't imply that it isn't feasible for other retirement accounts.

[00:07:21] [SPEAKER_00]: For example, if you were to max out your Roth IRA by contributing $7,000 in January

[00:07:27] [SPEAKER_00]: instead of throughout the year, your expected benefit would be about $350 or 5% of $7,000

[00:07:35] [SPEAKER_00]: in a typical year. Yeah, $300 isn't a lot, but do that every year and it can add up over time.

[00:07:43] [SPEAKER_00]: Whether or not you choose to max out one of your retirement accounts earlier in the year is up to

[00:07:49] [SPEAKER_00]: you. Though I don't see a huge benefit in doing so, if you're someone who needs every extra dollar

[00:07:55] [SPEAKER_00]: you can get, then maxing early should help. This is especially true if you max out early over many

[00:08:02] [SPEAKER_00]: years in a row. The longer you follow the max early strategy, the higher the likelihood of

[00:08:08] [SPEAKER_00]: absolute outperformance. Note, I've had a lot of people comment that many 401k plans will not

[00:08:16] [SPEAKER_00]: match your contributions throughout the rest of the year. That is, there's no true up provision

[00:08:21] [SPEAKER_00]: if you decide to max early. If this is the case, then you will probably lose more money by not

[00:08:28] [SPEAKER_00]: getting your full match than what you gain by being in the market earlier in time. Ask your

[00:08:35] [SPEAKER_00]: employer before maxing early as this could end up costing you more money than it makes you.

[00:08:41] [SPEAKER_00]: Either way, don't stress yourself out over this decision. The benefit of doing so isn't worth the

[00:08:47] [SPEAKER_00]: mental cost. You just listened to the post titled, Should you max out your 401k earlier in the year?

[00:08:58] [SPEAKER_00]: By Nick Majulie of of dollarsanddata.com. And I'll be right back with my commentary.

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[00:10:07] [SPEAKER_00]: This article reminds me of the perils of over optimization. While I understand that the name

[00:10:14] [SPEAKER_00]: of this podcast is Optimal Finance Daily, maybe we should start calling it Optimal Finance While

[00:10:21] [SPEAKER_00]: Keeping Your Sanity Daily. There are lots of little ways we can squeeze out a tiny bit more

[00:10:28] [SPEAKER_00]: return out of our investments. But I tend to disregard most things that would cause me to mess

[00:10:35] [SPEAKER_00]: around with the automation I've set up. For example, I invest in total market low fee index funds.

[00:10:43] [SPEAKER_00]: One time a listener wrote to me to ask why I wouldn't move all of my money over to a different

[00:10:49] [SPEAKER_00]: index fund that had an expense ratio that was 0.01% less. Another asked me why I wouldn't move

[00:10:58] [SPEAKER_00]: my emergency fund every year to a bank that was offering an interest rate that was half a

[00:11:04] [SPEAKER_00]: percentage point higher than my current bank. My answer to both of those questions is that I'm lazy

[00:11:10] [SPEAKER_00]: and the juice isn't worth the squeeze. Every time I mess with my setup, I'm adding complexity

[00:11:19] [SPEAKER_00]: for very little return. I'm adding another account I need to keep track of or I'm fussing

[00:11:25] [SPEAKER_00]: with my money without much benefit. As the father of index funds, Jack Bogle once said,

[00:11:32] [SPEAKER_00]: quote, don't do something, just stand there. And that's another edition of Optimal Finance Daily.

[00:11:39] [SPEAKER_00]: Thank you for listening, and I'll be back with you tomorrow for another post.

[00:11:44] [SPEAKER_00]: So I'll see you there where your optimal life awaits.