Today, I scheduled my last contribution of 2016 toward my 401(k) — my work-based retirement account — for April to hit the maximum allowable amount for the year. In March, I also hit the max for 2016 for my IRA — my personal retirement account.
Here’s why I think that’s a good idea.
An introduction to front-loading
Front-loading is exactly what it sounds like. Rather than putting a bit into my retirement accounts every month of the year, I load it all in at the front four months of the year.
Example: Suppose I wanted to contribute a total of $12,000 to my retirement accounts in 2016. I could put $1,000 in every month:
With front-loading, I would instead triple the size of my first four contributions so that I would get to $12,000 in total contributions by April:
It doesn’t make sense to front-load if you have to dip into your emergency fund because having to scramble to pay for an emergency could be more expensive than any gains you get from front-loading. It also doesn’t make sense to front-load if doing so will make you lose your company’s 401(k) match. Luckily, my company does what’s called a 401(k) true-upat the end of the year, wherein they make sure that anyone who’s contributed at least 6 percent of their income gets the whole of their match.
More time for growth
You might have noticed a lot of ugly colors and arrows on my last image. One mathematical way to think about front-loading is that instead of making twelve monthly contributions, I:
- Make my May contribution in January — four months early
- Make my June contribution in January — five months early
- Make my July contribution in February — five months early
- …and so forth…
Put differently, my May contribution gets four extra months to grow, my June contribution gets five extra months to grow, and so forth.
The expected total effect of this can be calculated as follows: With the normal method, my average contribution occurs at 6.5 months. With front-loading, my average contribution occurs at 2.5 months.
Given the long-term average return for stocks of 7 percent per year, the four extra months I get from front-loading is like getting an extra 2 percent return on my investments. For someone who contributes the max to their 401(k) and IRA accounts, that equates to $500
This 2-percent improvement shows up with real stock market returns too. Using S&P 500 data from 1950 through 2015 from Yahoo! Finance shows that front-loading contributions in the first four months of the year has produced bigger gains than regular contributions in 45 out of 66 years — or 68 percent of the time.
Summary data for returns for either method are as follows.
Regular monthly contributions
- Median: 5.9 percent
- Mean: 5.2 percent
- Standard deviation: 9.6 percent
- Median: 8.9 percent
- Mean: 7.5 percent
- Standard deviation: 14 percent
Note the larger standard deviation that comes with front-loading. Increased volatility isn’t unimportant, but is something I accept given my long investment horizon.
There’s one last little bonus when it comes to time: Contributions to traditional retirement accounts are made before tax, making my income look lower than it is for tax purposes. Increasing those contributions decreases the amount of my pay that can be taxed, and so front-loading my retirement contributions is effectively back-loading taxes. When I’m making big contributions early in the year, my tax rate goes way down; I pay just a 13-percent tax rate before it increases to 35 percent later in the year when I stop making big contributions, which means I keep more of my income earlier on to contribute to my retirement accounts.
I think of it as a free loan from the government to help my investments grow. 🙂
Now, to be clear, front-loading is far from easy. I have to live very lean in these first few months to have enough to make the necessary big contributions without dipping into my emergency fund. But having a few restrictive months at the beginning of the year proffers a lot more flexibility upon me for the rest of the year.
There are plenty of reasons why I might not be able to continue to contribute later in the year. Maybe I’ll get laid off, maybe I’ll jump at a great opportunity that requires me to leave work, or maybe I’ll just decide that I really want to buy something big.
None of these things are very likely, but it’s nice to know that I have the flexibility if I need it without having to worry that I’ll be able to contribute enough to my retirement accounts for the year.
But my biggest reason to front-load is the psychological one.
The beginning of the year is a special time for savers. We’re allowed to contribute to tax-advantaged accounts again, raises take effect, and performance bonuses and tax refunds show up in my bank account.
It’s also when my New Years resolutions are fresh in my mind, and I’ve still got the motivation to make the sacrifices necessary to achieve them.
Front-loading my retirement accounts allows me the opportunity to best take advantage of that extra motivation and that extra cash. And since it’s only for four months at a time, I can make a meaningful change in my personal finances without burning myself out.