It's only natural I follow up my "Don't Save for Retirement" blog post with a one on how to crush your retirement savings goals. I hope your goals includes a retirement savings goal. Whether you plan to save 15%, or max out your 401k and/or IRA, you should have a retirement savings goal you are working towards. The typical way people go about attacking their goal is taking the amount they want to save, and dividing it by the number of pay periods in the year. I'll show you a different and more effective way to do it.
If your budget is anything like mine, some months are more expensive than others. No matter how much I save and prepare throughout the year for Christmas, December always ends up being an expensive month. In contrast, January is one of the least expensive months in the year. I typically don’t take any vacations the first few months of the year, and I start off the year with intense motivation to accomplish my goals.
Spreading contributions out evenly throughout the year wastes all that extra motivation! Rather than waste the motivation, I thought, "surely, there must be a better way." And then, KAPOW!, I got inspired. I thought, why not front-load my contributions.
Automation has its benefits, but it can also cause us to be complacent about our savings. Automation is a double-edged sword when it comes to complacency. On the plus side, automation prevents you from having to think whether or not, and how much you want to save each paycheck. On the downside, automation can cause you to settle and not push yourself to save more, even if your expenses are lower in a given month.
Step one in front-loading is nailing down your goal. Maybe this is the first year you max out your IRA or 401k. Maybe you want to bump your savings rate from 10% to 20%. If you set a percentage based goal, convert the percentage to a dollar amount, and vice versa. For example, if your goal is to save 20% this year, and you make $50,000, multiply 20% by $50,000. Your 20% goal is $10,000. You should know your goal in both percentage and dollar terms.
Once you have your goal, it’s time to figure out your front-loading strategy. I’ll walk you through my front-loading strategy on one of my goals for the year: maxing out my 401k.
I’m going to go a little number crazy here, so, hopefully, everyone can follow along. The math isn’t too difficult to understand. To make the numbers easier, let’s assume I make $100,000/year. The 2017 annual max is $18,000. Maxing out my 401k the standard way means contributing 18% every paycheck ($18,000 = $100,000 x 0.18). Since I don’t have any vacations or other big expenses planned for the first three months, I want to get ahead of the game. Rather than a static 18% contribution throughout the year, I’ll start by contributing 30% of my pay for the first few months of the year. Eventually, I’ll have to reduce my contribution rate to avoid exceeding the annual max. A 30% contribution rate for the entire year would put me at $30,000 in annual contributions, far exceeding the annual limit.
A 30% contribution rate on a $100,000 salary equates to $2,500/month. If I keep my contribution rate at 30% for the first three months of the year, I’ll have saved $7,500. If I subtract $7,500 from the annual max, I’ll be left with $10,500 to contribute for the final 9 months of the year.
Over the final 9 months of the year, I’ll make $75,000 ($100,000 x (9/12)). My remaining contributions ($10,500) divided by remaining pay ($75,000) equates to a contribution rate of 14%.
I could drop my contribution rate to 14%, after three months, and still on pace to max out my 401k.
Furthermore, if I keep my contribution rate at 30% for the first 6 months of the year, I’ll be able to drop my contribution rate all the way down to 6% for the final 6 months of the year. I'll have to make sure I have enough left in allowable contributions at the end of the year, in order to take advantage of my company's matching contribution (it's important to keep your minimum contributions each paycheck at whatever amount is required to get your company's matching contribution).
The benefit to the front-loading strategy is the options I'll have later in the year. All the options consist of eventually reducing my contribution rate at a time when my expenses are likely to increase. Reducing my contribution rate will feel like a raise since my take-home pay will increase. Whatever I decide to do with the extra money, I’ll still be on pace to meet my goal of maxing out my 401k. A best case scenario would be not needing the extra money, and saving the money in a taxable account. The main reason I'm front-loading, though, is because I expect my expenses will go up as the year goes on. Even if I spend the extra money on a vacation, so what? I'll still be hitting my goal of maxing out my 401k because I sacrificed at the beginning of the year.
Maybe your goal is to max out your IRA. You may not have the money on hand to max your IRA all at once, but you can still apply the front-loading strategy. The 2017 IRA contribution maximum is $5,500 (if you’re under age 50). If you get paid twice a month, it means you’ll have 24 pay periods throughout the year. You could contribute approximately $229 each paycheck to max out your IRA, or you could front-load it.
Let’s say you are getting a $2,500 tax refund (I’m a fan of tax refunds). If you put the entire $2,500 in the IRA, you would only need to contribute an additional $3,000 to max your IRA. $3,000 is only $125/paycheck (assuming 24 pay periods). With the IRA (compared to the 401k), there are no matching contributions to worry about, so the sooner you max it out, the better.
Sorry for getting so math heavy, but I wanted to walk you through a couple of examples. The main point is, saving more at the beginning of the year, means the need to save less at the end of the year to reach your goals. Mind blown! Not only is having extra money later in the year nice, it makes you more likely to meet or exceed your goals.
Front loading is a bit more involved approach and it isn’t for everyone. It makes sense for those of you who have some flexibility in your budget and are willing to do a few calculations to make it work.
Remember, a lot of your friends and family may be trying to cut back on expenses at the beginning of the year. It can be far easier saying “no” to expenses at the beginning of the year, when everyone is attempting to cut back, than at the year-end when it seems like the money can't stop pouring out of your bank account.
Front-load your retirement account to get a strong start on your retirement saving goal, and you'll be able to cruise to the finish line.
What do you think? Will you make front-loading a part of your strategy or will you stick to the more conventional approach?