Bonus on the way? Don’t forget to make this small tweak!
I recently wrote an article that gives you the 411 on all things 401(k)s. It focuses on high-level details like what it is, the difference between regular and Roth options, withdrawal rules…I’ll stop here before I spoil the whole thing! If you haven’t read it, I encourage you to do so. I bring this up because I recently got a reminder from my employer to adjust my 401(k) contribution rate before bonuses were paid, and I wanted to remind you too! The examples below could be easily replicated by replacing the fake figures with your own.
The amount you contribute to a 401(k) is usually a percentage of each paycheck rather than a set dollar amount. If you aim to contribute the max ($20,500 for 2022), do a little math at the beginning of the year to determine what percentage of your paychecks totals $20,500.
Math Example
$20,500/24 = $854 per paycheck | $854 per paycheck/$3,000 gross paycheck total = 28% per paycheck
Example Explained
Divide the maximum allowable contribution for the year ($20,500 in 2022) by the number of paychecks you receive in a year (If you’re paid bi-monthly, you’d use 24). In this example, you should contribute $854 per paycheck to your 401(k) each pay period to contribute the maximum allowable amount.
Next, divide $854 by the gross amount of your typical paycheck (let’s use $3,000) to determine what percentage of your paycheck you should contribute each pay period. In this example, you should set your contribution percentage to 28% per paycheck to your 401(k) to reach the 2022 maximum. Note: You use gross pay instead of after-tax pay because pre-tax funds are subject to the 401(k) contribution limit. (You can contribute post-tax funds too, but that’s not what the limit applies to.)
Since we calculated the per-paycheck contribution percentage based on a "normal" paycheck amount, you will need to adjust the contribution percentage before your bonuses are paid, or you risk throwing away several months of employer-matching contributions — aka, free money!
As an incentive for employees to contribute to a 401(k), some employers contribute a small percentage of cash in addition to what you’re contributing to your account. This generous contribution is known as an employer match. Employer matching contributions aren’t required by law, so not all employers offer this incentive. However, if they do, it’s prudent to take full advantage of this free cash. There are 2 ways to do this:
Figure out the percentage of your contributions that your employer is willing to match, and plan to contribute AT LEAST that percentage to your 401(k) each pay period. Oftentimes, employers don’t match 100% of your contributions, so if you’re not in a position to max out your 401(k) contributions right now, odds are you can still take full advantage of the matching funds each year.
Adjust your 401(k) contributions when you receive spot or annual bonuses throughout the year to ensure that you can contribute at least the employer’s matching percentage with every paycheck. Since 401(k) contributions are percentage based, this can be tricky but you can get close if you use the tips below.
Let’s say your employer matches 50% of the first 8% of each 401(k) contribution. If you don’t contribute at LEAST 8% to your 401(k) each pay period, you won’t receive the maximum amount of matching dollars from your employer. This is why adjusting your contribution percentage BEFORE you receive a bonus is important! 401(k) contributions are percentage based, so if you receive a hefty lump sum bonus in a mid-year paycheck, you could risk maxing out your 401(k) before the last pay period of the year. For every pay period that you don’t contribute to your 401(k), you’re effectively throwing away employer matching dollars until the clock resets on January 1. (Note: It is possible to contribute after-tax dollars to your 401(k), but some employers don’t match after-tax contributions, so you’ll need to read your plan’s terms closely.)
Example
Now that you understand contributions and matching, let’s see how a bonus can affect your 401(k) contributions if you don’t adjust the percentage. Our example gross pay and bonus amounts are $3,000 and $5,000, respectively. In this example, your employer matches 50% of the first 8% of each 401(k) contribution.
Regular Pay Period: $3,000 x 28% = $854 contributed
Bonus Pay Period: $3,000 paycheck + $5,000 bonus = $8,000 x 28% = $2,240 contributed
$2,240 / $854 = 2.6 pay periods. In this example, you’ll max out ~3 months early and forgo 3 months (6 paychecks) of employer matching dollars if you don’t adjust your percentage.
$3,000 x 8% = $240 x 50% = $120. Your employer gives you (matches) $120 in each pay period that you contribute at least 8%. In this example, you’d throw away $720 in free money by maxing out 3 months early.
Note: These figures are over-simplified. I recommend using a pay stub from your last bonus period to help you with the math.
Spoiler alert: It’s tricky to contribute the exact $20,500 in 24 pay periods since it’s all percentage based. I lowered my contribution for the bonus pay period to my employer's matching percentage, but I’ll still lose one pay period of matching this December. That’s better than losing 5, though, which I would have lost had I not adjusted the rate before I got the bonus!
TL;DR
Lower your 401(k) contribution percentage before your annual bonus is paid, if applicable, to avoid maxing out early and losing employer matching dollars. This example was all about bonuses, but you’ll want to adjust your contribution percentage annually to account for any raises or other changes in income, too.