Financial Planning, Investment, Retirement Planning, Work and Career

Three Perspectives on Contributing to the 401(k): Dollar-Cost Averaging, Front-Loading and Back-Loading

When you have a buffer of savings and you want to invest that money, do you invest in small chunks spread out over time or in a lump sum all at once? Do you do a mix? How do you decide when to use which strategy? What do you pay attention to? How do you evaluate your investment returns? Maybe you don’t have a preference and just do what feels good or right for your situation?

Three Perspectives on Contributing to the 401(k): Dollar-Cost Averaging, Front-Loading and Back-Loading

Contributing to your 401(k) is a form of investment. As we strive to become diligent and prudent investors, it’s worth taking a look at some of the different perspectives investors generally use to contribute to their accounts. What are the advantages and disadvantages? As you will read, I don’t recommend one strategy over another. I share why my husband and I use a particular strategy given our particular situation during a particular time. From our story, I hope you’ll see why one strategy worked for us at one time and another worked better for us at another time. Ultimately, you need to decide what’s best for you. Knowledge is power. The more you learn, the more you become aware of what’s possible for you. As a result, you’ll be able to make informed financial decisions.

Before you consider doing what you’re about to read in the sections below, please read your plan documents or talk with your HR/employer to find out how your employer does the match (if this is part of your employee benefits). Employers have different ways of doing the 401(k) match. Without being aware of this, you could be losing on a portion of your employer match. Both our employers match on a payroll basis. We only get the match when we contribute at least enough to get the full match per pay period. For my husband, that’s six percent of his pay. For me, it’s three percent.

I also encourage you to read my previous post on What is a 401(k)? What is it Not? Getting Down to the Basics. For many people, having access to a 401(k) plan through an employer might be their first exposure to investing. How can you make such major, long-term decisions when you don’t have much of a clue what the plan is or what choices you have?

Dollar-Cost Averaging

One common advice in the investing world is never try to time the stock market. The market fluctuates from one day to another. Share prices go up and down all throughout the year. As such, it can be overwhelming and confusing trying to build an investment portfolio. This is where the dollar-cost averaging strategy comes in handy.

Dollar-cost averaging is allocating a fixed dollar amount to buy a particular investment at regular intervals over time. This means you get more shares when the price is low and fewer when it’s high. It’s a great risk management technique to handle market fluctuations. This strategy takes the guesswork out of investing while you keep adding money into the stock market.

For years, my husband and I contributed to our 401(k)s using this strategy. We didn’t plan it this way. This strategy allowed us to make sure we get the full employer match each year. In the beginning of each year we find out what the contribution limit is (the IRS gets to decide). From there, we divide the limit by the number of paychecks per calendar year. Whatever the number comes out on the other side of the equation is the amount we each allocate pretax to go into our accounts. Simple, right?

While we do pay attention to value indicators of our investments, we do much less so with those funds in our 401(k)s (as compared to those in our taxable accounts or IRAs). Over the years, we’ve come to like simplicity when it comes to investing. We generally keep up with what’s going on in the global market, but we don’t always exhaustively review all the fund’s financial numbers before making a purchase. Managing our investments is a lot of work. Sometimes, it’s nice to just keep adding money into the stock market at a regular interval and build a larger portfolio without having to think too much about it.

Dollar-cost averaging is also an effective strategy if you have a small amount of money to invest or you have a hard time saving. You don’t have to wait until you’ve accumulated a large sum before getting into the stock market. By setting your investment schedule this way (almost automatic once you set up early in the year through payroll), you make sure you continue to pay for yourself first.

Another scenario when this strategy comes in handy is if you have a hard time investing (such as you can’t decide when is a good time to put your money into the market and/or you’re afraid you’ll miss the next big market drop). Dollar-cost averaging into the market can help you psychologically get started investing.  By investing in a small amount, say $100 per month, you can feel like you’re building a portfolio, while not worrying too much about price and volatility. That way, you can accumulate wealth, while minimizing the emotional toll of the stock market’s price fluctuations.

And just like anything about investing, there’s always at least one caveat we need to consider. While doing dollar-cost averaging, you limit your risk by not investing a large lump sum of money all at once (what if your timing was off?). At the same time, you can be missing out on opportunities, too, if you have more money to invest. What if your investments continue to go up for months? You’d miss out on a lot of potential gains by delaying your investment. See the front-loading strategy section (below) to learn more about other limitations.

Front-loading

As mentioned in the previous section, for years it was natural for both my husband and I to use the dollar-cost averaging strategy due to the structure of our employer matches. This method was easy. Very little math was involved. Then, in year 2014, I wanted to front-load my 401(k) before I take maternity leave. Front-loading an investment is putting a lump sum of money into the stock market all at once. In the world of 401(k)s, this strategy describes investors who want to max the contribution limit for the year as early as possible.

In my example, I was going to begin my leave in August, and I wanted to put in as much pretax money as I could to max my contribution limit before that. I also needed to make sure I continue to get my employer match until the end of July. How did I come up with the amount I needed to set aside each pay period? First, I counted the number of pay periods I had, which was 15. Then, I divided the 2015 contribution limit (which was $17,500) by 15. The result was $1,166.67. That was the amount I contributed per pay period from January to July, 2014. The computation was easy. My employer doesn’t put a percentage limit on how much of my pretax paycheck I can put toward my 401(k) account.

This was somewhat of a front-loading strategy. I spread out my contributions into less pay periods. However, a full front-loading strategy would’ve been to put in as much as I could into my 401(k) account in as few pay periods as possible.

Can you use the front-loading strategy if you work the whole year? Absolutely! However, there are various things to consider and the math can get messy. Before going further, let’s walk through an example together below. Forewarn: don’t let all the numbers and calculations scare you. Follow through the logic, read about some of the reasons investors generally like this strategy and then come back to study the example again.

Sarah’s Example:

Sarah’s annual earning is $ 120,000, and she has 24 paychecks per year.

Her employer offers a 50% match on up to 6%. Sarah needs to contribute at least 6% of her pretax earnings per pay period to get the full match from her employer.

As Sarah wants to get the full employer match every pay period, 6% of $120,000 is $7,200, which results in $300 per pay period [$7,200 / 24].

Subtracting $7,200 from this year’s contribution limit ($18,000) results in $10,800. $10,800 is the amount Sarah can front-load and still get her full employer match throughout the year.

Where to go from here? Sarah knows that her employer only allows employees to put aside up to 40% of earnings per pay period into 401(k). With this information, we subtract 6 from 40, resulting in 34, which is 34%. That is, after contributing enough to max the employer match (6%), Sarah can still put in 34% more of her earnings. So, what’s 34% of her earnings per pay period (which is $120,000 divided by 24, resulting in $5,000)? It’s $1,700 ($5,000 x 34%).

Then, we divide the amount Sarah can front-load [$10,800] by $1,700, and we get 6.35. This number, 6.35, is the number of pay periods Sarah will have maxed her front-load amount.

With all these numbers in hand, we can calculate how much Sarah will be contributing to her 401(k) during the first 6 pay periods, on the 7th pay period and then from the 8th to 24th period.

To calculate the amount for the first 6 pay periods, Sarah adds $1,700 to $300, resulting in $2,000. On the 7th pay period, Sarah add $595 [$1,700 x (6.35 – 6)] to $300, resulting in $895. Then, for the rest of the pay periods until the end of the year, Sarah will be putting in $300 per pay period just to get her full employer match.

Let’s double check on the numbers.

$12,000 (during the first 6 pay periods) + $895 (on the 7th pay period) + $5,100 (the remaining of the 17 pay periods) = $17,995.

This number is very close to the year 2016 401(k) contribution limit! In a nutshell, Sarah needs to contribute 6% to her account each pay period to receive the full employer match. Her employer also puts a ceiling limit on how much she can contribute per pay period, which is 40% of her earnings. With this in mind, Sarah still can front-load the bulk of her contributions early in the year (that’s $12,895 during the first 7 pay periods!) and leave enough room to contribute the match percentage for the rest of the year.

If you choose to go this route, you need to know all the features of your 401(k) plan. We had to go through some crazy math calculations with Sarah’s case scenario. Make sure you double and triple check on your numbers. Put yourself in a situation where you are getting the full employer match until the final pay check of the year. If you expect any raises and/or bonus, you need to adjust the numbers as you go. Some employers/HR will stop your contribution once the limit is reached. Others don’t. Find out from your payroll.

Now with all those calculations behind, it’s time to look at some reasons why front-loading might work for you.

Taking Advantage of Market Returns as Early as Possible

In the world of 401(k) plan, the very definition of front-loading is maxing the contribution limit in as few pay periods as possible. When you do this, you’re giving your contributions/savings more time to bring in market returns.

Postpone Paying Taxes

When you front-load your 401(k) contribution early in the year, you are shielding more of your pretax earnings from various taxes (as I wrote here, you’d still have to pay the full amount for Social Security and Medicare). In Sarah’s case, she’ll be putting away $12,000 in her 401(k) within three months. Let’s say her tax bracket is at 25%. This is $1,000 of money that would have gone to pay taxes each month. By front-loading, she instead gets to invest all this money early in the year. And this money has the potential to grow while invested.

Minimize Federal Income Taxes

Your 401(k) account is a tax-deferred account, meaning that the money you put in won’t be subject to federal income tax. If it’s in your financial plan to only work for a certain number of months in that particular year or every year, you can plan it so that you only work the number of months it would take to max out your 401(k) and possibly other tax-deferred accounts, hence, minimizing the amount of federal income taxes you pay to the government.

Maxing the Contribution Limit

If you know ahead of time that you’ll be leaving the job in the later part of the year (such as family leave, travel, mini retirement), this strategy can help you max your contribution limit as quickly as possible (assuming this is part of your financial plan). My maternity leave was a great example.

Tax-Free Growth

The more money you front-load to your 401(k) account, the longer you allow this money to grow tax free. If given the option to invest $100 in January or in November assuming you don’t have a clue which direction the stock market is going to go, which would you choose? Most people would choose to invest the $100 in January for two reasons: (1) the $100 begins to earn dividend or interest assuming the investment offers a yield; and (2) that $100 has the potential to grow in your portfolio in the next 10 months.

Back-loading

Technically, this is not a strategy (it’s probably not even the correct label). I’m presenting this as an option because we had to do this in year 2015 and 2016. When I went back to work in May 2015, I had to catch up maxing the contribution limit. I figured out how many more paid periods were left in the calendar year, divide that number by 2015’s contribution limit, and the resulting number was the amount I allocated to my account each paid period. Again, the calculation was easy. My employer doesn’t have a contribution ceiling limit. Then, in year 2016, from January to June I was only contributing just enough to get the full employer match. Back in late 2015 my husband and I decided we were going to save up cash and do other forms of investments. Nothing happened during the first half of 2016. And we were sitting on too much cash. We also didn’t like how much taxes we were paying. From July onward, we have been putting lots of money into our 401(k)s once again. We seriously need to lower our taxes (taxes trim your paychecks!).

Concluding Remarks

Over the years, my husband and I have maxed our contribution limit using different timing strategies (dollar-cost averaging, front-loading and and back-loading). Sometimes, the strategy we used was a natural part of our financial planning. Other times, the logic was more intentional. One thing is clear: we have been active participants in our financial planning. Sometimes, we think ahead and plan accordingly. Other times, we assess our current situation and be open to revising our original financial plans.

We haven’t had enough time to test out which strategy brings us the biggest return on our money. What matters the most to us has been the fact that we have been continuing to build our investment portfolio on a consistent annual basis. For us, this is what helps us accumulate and preserve wealth over time. Whichever strategy you use, make sure you have a financial plan and understand why one strategy works better for your financial situation (and not just based on chasing returns).

How do you invest your money? Are you the dollar-cost averaging investor or a front-loading investor?

Which one appeals to you more?

Was there a time when you needed to back-load?

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