The Case Against Front Loading Your 401k

One common piece of advice I often hear in the financial independence community is that you should front-load your 401k and max it out as early in the year as possible.  Unfortunately, for most people pursuing FI, this is probably the opposite of what you want to be doing!

There are certain times where front-loading may be ideal, such as if you feel your job is unstable or you plan to leave work before the year is up, but in the average case of spending the entire year with the same employer, you might be better off taking a second look at your investment strategy.  It’s important not to look at the 401k in isolation, but instead consider the timing options across all of your different investment options during the year.

Below, I’ll go over why front loading in general may sound appealing, how that applies to the various investment buckets out there, some caveats to be aware of, and then some examples to demonstrate why front-loading your 401k probably isn’t the best idea.

The Worst Way to Execute Front-Loading

In a bubble, front-loading an investment account seems better than the alternative of dragging out contributions over time.  After all, we expect the market to move upwards over the long term, so the sooner you get the money invested, the sooner it can start to grow!

This shares a lot of parallels with Lump Sum versus Dollar Cost Averaging, of which thousands of articles have been written about.  To summarize all of the ones that were based in math, Lump Sum is better unless you have the ability to time the market (which you probably don’t).

Knowing that putting available cash in the market sooner is better than later, then front-loading a 401k seems like the best plan, right?  Wrong!  The better conclusion to draw from this is that all money should be invested as soon as you can invest it.  Basically, you should avoid holding cash because it will drag down your returns over time.

This means if you’re saving up cash at the end of the previous year (in order to cover next year’s regular expenses) to then set your 401k withholding above 80% (a strategy I’ve heard people brag about), you’re completely missing the point!  You should have “front-loaded” that money into investments as soon as you got it instead of holding on to it in order to pull off maxing your 401k early.  Holding onto cash so you can redirect more of your paycheck towards the 401k defeats the entire point of getting money into the market sooner rather than later.

In fact, not only does this strategy miss out on potential gains because you’re holding cash, but it’s actually the least efficient way to invest across the different options available, even if you did manage to generate $18,000 to invest right at the beginning of the year.

Why Do We Invest in 401k’s to Being With?

There are two primary reasons that most people invest in a 401k:

  1. Employer matching contributions
  2. Tax Savings

The first one is basically free money and pretty much everyone should take advantage of it if they have the option.  The second is extremely powerful for people seeking FI because taxes that are deferred during the earning years can potentially be avoided all together after early retirement!

So any 401k strategy should ensure that you’re getting the full employer match and also taking advantage of any tax savings available to you.  Making sure you’re getting the full employer match may require you to spread contributions over the entire year, but some employers offer a “true-up” that tops off any match you should have gotten after the end of the year.

The good news about the tax savings is that it doesn’t matter at which point during the year you make contributions to the 401k.  As long as you get all the contributions in there before the end of the year, you get the entire tax benefit.  This part is important.

Which Investment Bucket is Best for Gains?

So far, I’ve only been talking about 401k’s (specifically a Traditional 401k involving pre-tax contributions), but it’s important to consider all of the options available to you when coming up with an investment plan.  Other common options are Roth IRAs and regular brokerage (taxable) accounts.  HSA’s are kind of special and you should probably max it out if available, but I’m going to leave it out of this particular analysis.  In addition, 457’s, 403b’s, and any other pre-tax investment options available to you are basically synonymous with 401k for this post.

So here’s the 3 investment options we’ll be looking at:

  1. Traditional 401k (pre-tax going in, fully taxed coming out)
  2. Roth IRA (already taxed before going in, tax-free coming out)
  3. Brokerage (already taxed before going in, only gains are taxed coming out)

Specifically, let’s look at how gains are handled in each account:

  1. Traditional 401k: Gains are fully taxed as regular income when withdrawn
  2. Roth IRA: Gains are never taxed when withdrawn
  3. Brokerage: Gains are taxed at an advantageous rate when withdrawn

With that in mind, it should be obvious which account is best to have the most gains in: Roth.  That’s followed by a brokerage account because they are taxed at a lower rate, and then finally the 401k is last because all gains are taxed as regular income at the full tax rate.

Hopefully you’re still with me at this point, I promise I’m getting to the point soon!  I thought it was important to explain a few key concepts that will tie this whole thing together nicely at the end.  So far we’ve learned that you should invest as soon as money is available and that 401k’s are good because of matching contributions and tax savings, but they also happen to be the least tax-advantaged account when it comes to investment gains.  Now we can drive it home.

The Optimal Way to Time Investments Across Accounts

With all of the above information, you may have already determined why front-loading your 401k is probably a bad idea.  Over the course of a year, whichever account you put money into first will be the account with the highest gains at the end of the year.  As 401k’s have poor eventual tax treatment for those gains, it would be better to invest in Roth or taxable earlier instead.

In fact, you want to make sure that you’re taking full advantage of an employer match and tax savings by maxing out the 401k, but it may actually be in your best interest to back-load the 401k if possible!  This way more of your gains end up in Roth and Brokerage accounts instead of the 401k which will potentially save you money on taxes in the long run.

Therefore, the optimal strategy is to do the minimum possible contribution to the 401k each month to not lose out on (or delay) any matching contributions and defer any other cash flow each month to a Roth IRA until maxed, then finally a brokerage account.  Then towards the end of the year, depending on how much you are investing each month, you should increase your 401k contributions to reach the full $18,000 by the end of December.

Now that I’ve laid out everything we need to know, let’s get into something way more fun: Examples and Numbers!

A Simple Case Study

To look as this optimal plan in action, let’s look at someone making $90,000 gross each year that is able to save $3,000 each month.  This person makes a little too much to deduct any Traditional IRA contributions, but is still able to utilize a Roth IRA directly.  With $3,000 to invest each month, they will be able to both max out the full $18,000 in a 401k, the full $5,500 in a Roth IRA, and still have $12,500 to invest in a regular brokerage account.  Their employer will also match up to $100 (or 1 and 1/3%) each month with a true-up in January if the account is maxed out early.

Additional Assumption:

  • 7% Annual Gains (the number choice doesn’t change any conclusions as long as it’s positive, it’s simply to show growth)

Below, I’ll show the cash-flow table for each scenario, but here’s the final account balances at the end for the 4 different scenarios I tested:

As you can see, most of the different strategies end up with the same total balance across accounts because the full $3,000 was invested each month.  The only one that was lower was the old-school, front loaded 401k where they had to wait until the year was over to get the rest of the matching contributions (the true-up), so those funds didn’t have a chance to grow at all during the year.

Another important note is that the amount contributed to each account was exactly the same at the end of each year.  $18,000 was contributed to the 401k (+$1,200 match), $5,500 to the Roth IRA, and $12,500 to the brokerage account.  The only difference was the timing of those contributions to each account over the year which changed the final balances.

As we discussed above, the Roth IRA is the best to eventually withdraw from because it’s entirely tax-free.  After that is the brokerage account because only the gains are taxed and at an advantageous rate.  Finally, the Traditional 401k is the worst to eventually withdraw from because it will be taxed at the full regular income rate.

NOTE: An early retiree with low yearly spending should be able to avoid almost ALL of these taxes if they plan out their withdrawal strategy well, but that doesn’t change the fact that the potential taxes for each of these accounts still falls in the order above.

The order of the 4 scenarios I tested above are ordered from best to worst, so front loading the Roth IRA and back loading the 401k is the optimal strategy.  This is because more investment gains have been funneled into the Roth IRA and brokerage accounts, which is better than those same gains sitting in the 401k.  You can explore the specific monthly contributions of each scenario below:

Front Load Roth IRA and Back Load 401k

This scenario involves contributing the minimum to still get the match each month, but focuses all additional cash flow towards the Roth IRA to max it out as soon as possible.  Cash flow after that goes towards the brokerage account while still getting the 401k match, then all cash flow is redirected to the 401k for the second half of the year to make sure it gets maxed out.

Based on the final account balances of each account, this is the best strategy out of all the ones tested.

Balanced Contributions All Year

This scenario involves making the exact same contribution to each account every month except for a small change in December to max out that last $4 in the Roth IRA.  This strategy is by far the easiest to automate and pretty much breaks even with the next strategy.  If you like simplicity, this is probably the way to go.

Front Load Roth IRA, then Front Load 401k but Avoid the True-Up

This scenario takes an interesting approach of maxing out the IRA first (good) while still getting the 401k match, but then directing all investing towards the 401k to front load it (bad).  They did still manage to leave enough late in the year to not delay the 401k match via the true-up (good).  As I mentioned, this scenario pretty much ties the balanced approach above, but is just as difficult to execute as the best strategy at the top, so I’m not sure why anyone would do this.

Front Load 401k (using the True-Up), then Roth IRA, then Brokerage

This is the front loading strategy that inspired me to run the numbers myself and write this post.  All money is directed toward the 401k at the beginning of the year to max it out as soon as possible, then the Roth IRA is filled, and finally the brokerage account is contributed to at the end of the year.  This causes two negative impacts.  First is the delaying of the matching contributions until January of the following year because they didn’t have a chance to grow during the year.  Second is that most of the investment gains happened in the 401k which is the least advantageous place for them to happen out of the 3 accounts available.  Both of these combine to end up in an overall worse scenario than any of the options above.

When Front Loading Might Make Sense

In the scenario where you plan to be working at your job for the full year, hopefully you were able to follow along and agree that front loading your 401k is a bad idea.  As I mentioned in the intro, there are however a couple scenarios where maxing it out as early as possible may make sense.

First, if you plan to leave your job or your job is at risk, it might make sense to max it out while it’s available.  Contributing through a paycheck is the only way to get money into a 401k as a regular employee, so if you aren’t going to be getting paychecks in the future, contribute as much as you can, while you can, in order to get the tax benefit.  One important caveat is that this could end up hurting you if you manage to get another job in the same year that offers a more generous match!  They would also have to allow access to the 401k within the first year and pay you enough to max it out on less than a year’s worth of paychecks, but it’s certainly possible.

Second, if you happen to be utilizing a Roth 401k, then front loading the contributions would make sense because the gains in that account will never be taxed, much like the Roth IRA.  For most seeking FI and early retirement, using a Roth 401k instead of a Traditional one is probably a terrible idea because you’ll save much more on taxes over the long run with Traditional, but there are some edge cases where a Roth 401k option may make sense.

Third, if you are taking advantage of the Mega Backdoor Roth involving after-tax (non-Roth) contributions to a 401k and then rolling them over into a Roth IRA, then the specific rules of your plan regarding when those contributions can be rolled out and how that relates to your regular 401k contributions may change the outcome above.  If this applies to you and you decide to crunch the numbers, be sure to let me know in the comments below!

Extra Notes to Consider

  • While I mostly focused on the difference in gains between the different account options, another consideration is that dividends in a brokerage account may be taxed as you get them.  This does change the math slightly, but doesn’t change the overall conclusion.  The amount this influences will heavily depend on what exactly you are invested in within the brokerage account, so I can’t provide an exact number.  In our own situation, the difference was ~$10 each year.
  • One benefit I’ve seen cited as an advantage of front loading your 401k is postponing taxes.  Yes, there will be less taxes taken out of those initial paychecks with a really high 401k contribution %, but you’re still paying the same amount of taxes at the end of the year.  If you really wanted to optimize this tax cash-flow, then you should set a really low withholding at the beginning of the year, then bump it up to the necessary amount for the last few months to top off your total yearly taxes for the year (aka, back load your tax withholding).  This is perfectly legal and doesn’t cause any tax penalties, but does require filling out a couple W-4’s during the year.  You could optimize one step further if you’re into credit cards and not withhold anything!  I’ll let my buddy Keith walk you through that whole process if you’re interested HERE.  Anyway, postponing a small amount of taxes is not a good reason to front load your 401k!
  • Another execution strategy I’ve seen to front loading the 401k is to dip into an emergency fund for regular expenses while the paychecks are going almost entirely to the 401k at the beginning of the year.  If you’re doing this, then I’d argue you’re missing the entire point of the emergency fund.  If you really have that much of a buffer you don’t actually need, then reduce the size of your emergency fund and invest the rest right away!  That extra drag on your investments created by the cash is going to significantly outweigh any gain you might think you’re getting from front loading your 401k.

Hopefully someone out there will take a second look at their 401k strategy and possibly change it for the better.  My advice is to stop holding on to cash to execute weird timing strategies with your 401k that end up being sub-optimal anyway.  If you have free cash for investing, then immediately invest it!

To optimize your own plan, first make a rough outline of your overall investments for the year, then order those accounts by which one has the best tax treatment on growth.  Typically, this will mean maxing out Roth accounts first (if you’re using Roth at all), then brokerage, and finally any pre-tax accounts like a 401k, Traditional IRA, 403b, 457, or anything else where taxes are deferred.  Remember, you get the same tax savings at the end of the year regardless of when you put the money in.

And at the very least, be sure you’re not missing out on any matching contributions!  That’s the best part about most 401k plans.  Even if your company does do a true-up in the following year for any missed matching contributions, there’s no reason to delay that money getting into your account.  The sooner the match gets in there, the sooner it can start growing.  As far as I know, there is no time limit on when a company actually gets those true-up contributions into your account, so it could be several months into the following year before you see them at all.

What do you guys think?  Is there some other benefit to front loading that I’m missing or is the general advice I’ve heard to front load 401k’s just not very good advice?  My math says it’s a bad idea, but maybe you’ve found otherwise.  Let me know by leaving a comment below!


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17 thoughts on “The Case Against Front Loading Your 401k

  1. When I saw this headline I was like no, this is totally wrong.

    And then I started reading. I got to the point where you said you’ll end up paying more in taxes and I thought well for early retirees they just execute the Roth conversion pipeline and hardly pay any tax anyway.

    But you’re still right because if you execute your strategy, there’s less money (statistically) that you have to convert for the pipeline.

    Great post!

    1. Thanks FIBY!

      You’re right that the tax part could end up being a moot point for very early retirees with low expenses because pretty much all taxes upon withdrawing will be avoided. Of course, that assumes current tax law stays the same which might not be the case.

      Overall, someone with that eventual no-tax plan should still execute the optimal strategy above to minimize unnecessary funds in the 401k because there’s no downside. Only upside if there eventual plan changes due to their own personal choices or tax law changes.

      1. Yeah, there’s definitely the risk that the Roth conversion pipeline gets closed sometime down the line. I do agree they should still do this because if they do, there’s less money they have to convert, so more of their money will be converted before the pipeline gets closed (in this hypothetical).

  2. Crap, just realized after reading this that my employer doesn’t true-up matching. I was one payment away from finishing my front-load and thereby not getting matched contributions for the rest of the year. I dropped my contributions down to the matched level and should be able to make it another 6 PPs or so before it’s maxed.

    Thanks for the article, wish I had known sooner!

    1. Glad I could help Brandon!

      Getting all of the matching contributions is definitely priority #1. After that you can manipulate the timing across accounts to optimize it a little further.

    2. You can still get your employer match but you will have to contribute to a POST tax account. I’ve had to do this in the past. Don’t miss out on tjat match!!

      1. Oh really? Does that mean contributing to a Roth and then pulling out the extra contributions at the end of the year (since I’ll have maxed it)?

        Thanks!

        1. After-tax is different from Roth and not all employers offer it. You’ll have to check with your HR to see if the after-tax is an option and whether or not it would allow you to continue getting the match.

  3. Can you explain your statement :”For most seeking FI and early retirement, using a Roth 401k instead of a Traditional one is probably a terrible idea because you’ll save much more on taxes over the long run with Traditional”.
    Wouldn’t the hit you take paying taxes on your original contribution to a Roth 401k, and then only paying income taxes on the employer contribution(and its growth) if and when you withdraw it, be a lot less than delaying the tax on your original contribution to the traditional 401k and paying the income tax on that contribution, the company match and both of their growth when you withdraw it? Or if you wait until you have to take it out as a RMD, the income might put you in a higher tax bracket and effect the taxability of your social security benefits as well as increase your Medicare premiums?

    1. For most people seeking early retirement, they are going to open up opportunities to get money out of the tax-deferred accounts and pay $0 in taxes. All of those years between full time work and traditional retirement age (where social security and other items kick in) will probably have a very low tax rate compared to your earning years. You can use this time to convert money from tax-deferred to Roth and avoid taxes altogether.

      For example, you could defer 25% in taxes at your marginal rate now, then pay 0% when rolling out an amount equal to the standard deduction and personal exemption each year in retirement. That’s a huge difference compared to paying the full 25% rate now to use the Roth instead.

      I covered tax optimization over a lifetime at a high level here:
      http://moneymetagame.com/fi/optimizing-taxes-over-a-lifetime/

      Also, I got into more detail on how someone could actually execute a Roth Conversion Ladder to minimize taxes from those tax-deferred accounts we’re talking about here:
      http://moneymetagame.com/fi/early-retirement-cash-flow-with-the-roth-ira-conversion-ladder/

    2. Roth IRA not subject to RMD and distributions (qualified) will not increase your AGI. Roth 401k plan can be rolled to Roth IRA prior to 70-1/2.
      Employer contributions must be pre-tax, so they are not Roth contributions.

  4. You need to add another situation that front loading makes sense. If you are making a ton of money, are already maxing all other savings vehicles and have excess cash then you might as well front load.

    1. Hi Hin,

      The situation you describe is exactly the situation I covered in the post. If you’re able to max out all of your tax-advantaged space and invest additional cash in a regular brokerage account, my conclusion was that it might make sense for you to back-load (instead of front-load) the pre-tax accounts.

  5. I think you have covered this before, but the investment options in a typical 401k plan suck. Maximizing outside accounts first offers better growth options. Although your 401k plan may get a match (not all employers make matching contributions) and that helps goose your returns (or cover the outrageous fees).
    The exception would be a Solo (individual) 401k plan. If you are in the FI space, you may already be self-employed.

    1. I don’t know if a typical 401k plan has terrible investments options, but I know some do.

      Even if a 401k has poor investment options, the match still makes sense if it’s available. In the case of a 401k with terrible investment options AND no match, there is still a decent change that it’s worth contributing to. This will depend on your tax bracket, future plans, expense ratios, and how long you plan to be with your employer (among other things), but I’ve seen a few people run the numbers and investing in the bad 401k still came out ahead.

      Bad investment options or not, tax-deferred space can be extremely valuable. I’d definitely run the numbers before I made a decision either way.

      1. I worked for financial planning and investment firms for over 20 years, even our own plans came up short. The main issue is fiduciary risk, plan sponsors don’t want to offer too many options or anything other than Vanilla. They are worried about getting sued. There is also a lot of misunderstanding of risk and investments to try to educate through. Most participants invest a ton in cash, fixed options and their company stock.
        Plans are sold by salespeople, not impartial advisors. There are also too many folks who need to get paid that negatively affects the plan returns. Many plans use target date funds that are a simplistic way to invest and takes only age into consideration.
        I’m not saying that the plans should be avoided, merely that the options are limited. Most plans won’t allow any stock, some are tied to a single fund family. If there is a match (that word is misused), it should cover the extra fees. Some plans use profit sharing contributions in addition to dollar matches, others skip the match and make only PS contributions.
        I spent a lot of time arguing with folks over taxes, which have never been a consideration for me. I am old enough to remember when most folks saved post-tax for their retirement if they weren’t covered by a DB plan at work. I also mentioned that I would maximize outside accounts first, tax-deferred or otherwise. Of course, I am self-employed now, so I have many more options available.

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