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  • How I earn extra 1.45% return without risk in my 401k account

    Posted by Frugal on April 13th, 2006

    The annual 401k contribution limit is $15K in 2006 now. Every year I always contribute to the max allowed by the law. My company allows the worker to contribute up to 60% of the salary. 60% of my salary at about $100K is $60K, far exceeding over the $15K annual limit. At the first thought, one would think that 60% is probably for the people whose salary is around $25K, but choose to crazily contribute 60% of the income into 401k account. Obviously, I don’t know of anyone who can live on a $25K – $15K = $10K pre-tax income. But after a little contemplation, I foud out this trick of earning extra 1.45% return without any risk in my 401k account.

    Here is how I do it. I simply contribute at the maximum possible rate of 60% at the beginning of every year. My investment choice is usually cash/bond at Fidelity which is yielding about 3.8% APR. Now if you look at the following comparison table, using 26 bi-weekly contributions:

    pay#

    balance of regular contrib.

    upfront contrib.

    balance of upfront contrib.

    1

    576.93

    2,307.69

    2,307.69

    2

    1,154.70

    2,307.69

    4,618.76

    3

    1,733.32

    2,307.69

    6,933.20

    4

    2,312.78

    2,307.69

    9,251.03

    5

    2,893.09

    2,307.69

    11,572.24

    6

    3,474.25

    2,307.69

    13,896.85

    7

    4,056.26

    1,153.85

    15,071.01

    8

    4,639.12

    15,093.04

    9

    5,222.83

    15,115.10

    10

    5,807.39

    15,137.19

    11

    6,392.81

    15,159.31

    12

    6,979.08

    15,181.47

    13

    7,566.21

    15,203.66

    14

    8,154.20

    15,225.88

    15

    8,743.05

    15,248.13

    16

    9,332.76

    15,270.42

    17

    9,923.33

    15,292.74

    18

    10,514.76

    15,315.09

    19

    11,107.06

    15,337.47

    20

    11,700.22

    15,359.89

    21

    12,294.25

    15,382.34

    22

    12,889.15

    15,404.82

    23

    13,484.92

    15,427.33

    24

    14,081.56

    15,449.88

    25

    14,679.07

    15,472.46

    26

    15,277.45

    15,495.07

    Do you see how I end up extra (15495.07 – 15277.45) / 15000 = 1.45% at the end of the year? After the year is over, all the money in both cases will be earning at the 3.8% APR. However, by simply paying myself first before IRS every year, I end up getting extra $217.62 or 1.45% yield every year. I have been doing this for several years now, and IRS has never complained (since my 401k account gets to the money first). Certainly this strategy is not for everyone. There are three problems with this:

    1. You need to have a sufficient cash reserve in the beginning of the year to cushion the lack of after-tax money coming in.
    2. Your contribution now is not at the even rate, and therefore, if you choose to contribute to other investment choices, you have extra risks of getting into market at the wrong time (or right time for that matter). Or you can phase in your contribution dollars evenly back into the market yourself.
    3. If your company has 401k match, it is possible that you may lose some match dollars with this uneven contribution rate.

    In any case, this shows clearly the advantage of paying yourself first over the tax man (especially if you are a business owner). You can also appy the same principle outside of the 401k account. On the W4-form, you can reduce the paycheck withholding amount in the beginning of the year, but then pay extra at the end of the year to avoid underpayment tax penalty. I use my tax calculator near the end of every year to underwithhold a little bit throughout the year, but catch up with extra tax payment at the end of year. But of course, in that case, your extra dollars may or may not go as far because although the total amount is not limited to $15K, whatever extra money that is earning returns needs to be taxed (at some 20 to 40% marginal tax bracket) unless you put the extra money into your Roth IRA or (spousal) IRA accounts. So don’t delay your contribution to Roth or regular IRA accounts until the April 15 of the next year. You pay yourself extra one-time return by contributing on Jan 1st of that tax year which is 1 year and 3.5 months earlier than contributing at the last minute. And if you do this every year, those extra one-time returns are not a one-time event, but a consistent annual extra return dollars that you pay yourself.


    More related posts:
  • Pay Yourself First: Under-withholding Taxes
  • Roth IRA vs 401k/Traditional IRA

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    18 Responses to “How I earn extra 1.45% return without risk in my 401k account”

    1. fivecentnickel.com Says:

      Carnival of Personal Finance #44…

      Good morning, and welcome to the 44th edition of the Carnival of Personal Finance. Coming on the heels of two somewhat ‘elitist’ Carnivals, I’ve decided to return the Carnival to it’s inclusive roots. If an on-topic post was sub…

    2. Akhil Jain Says:

      If your company also contributes then this is not a very good idea. You get company contribution only if you conribute in a given paycheck. In this case you will lose company contribution after paycheck number 7

    3. Tim MMF Says:

      60% that’s a lot. I’ve never heard of a company allowing someone to contribute that much, I didn’t even know that was allowed legally! Good post!

    4. frugal Says:

      Akhil, you’re right about company match. But you can also come up with a different schedule of contribution to take advantage of the maximum company match percentage, while at the same time, making upfront contribution as early as possible. By the way, my company is matching 401K (finally), and accomodating weirdos like me and more often the procrastinators who contribute last minute. My company will calculate the total amount of match by treating all contribution in the same year evenly, and then adjust for the match amount properly at the end of year. So for me, I will get most of my match dollars (which is not much) at the end of the tax year.

    5. Anonymous Says:

      60% is nothing. My company allows 100%.

    6. Novice Says:

      My employer does not provide a match at all.

    7. Bill Carson Says:

      401K’s are ripoffs. They are only for people not disciplined enough to contribute to they’re own retirement. You pay fees to a company that buys mutual funds for your companies’ retirement plan. You are paying fees to that company which is paying loads(usually) to the mutual funds they are buying. Anyone can track the exact stocks there mutual funds are buying by going to it’s website. You can mirror these holdings on your own very cheaply in a ira-based online broker with minimal fees. My company match(3%) compensates these management fees, but when I asked If I could have my deductions and Company match put in my own retirement account instead of my companies program, I was told no. It was State law that I had to be in the company plan. Why? I won’t get my social security back (I’m 30), so why can’t I control my 401k? Since controlling a portion of our SS will never be a possibility, why can’t we at least manage our own 401k’s when it is so easy with the internet to match our favorite funds holdings?

    8. Frugal Says:

      Bill,
      You can get your money “back” into your own IRA account if you change your job. It’s a bit unfortunate, and I wish there are other ways.

    9. cecil Says:

      I work for home depot, and everyone knows what has happend to my company. i need to find out what i should do with my 401k? alot of people say go all stock! well the stock goes up and down, and it hasnt split since nardelli took over. well my question is. i want to know how to invest my stock? should i go all in on like a mutual fund, international, equity growth, basic, small company equity, or equity value. these seem like good funds, like one is the dodge and cox fund. it seems like an ok stock, it has gone up alot but had declined hard in the past. im just worried about losing or not gaining on this. if you have any good choices i have laid out, i would appreciate it if you would help me out. thank you

      cecil

    10. Frugal Says:

      Cecil,
      The best thing is to read my blog on my market thinkings. Market changes, and my thinking changes too. Currently, I would suggest to put in your money in June to October AFTER the general stock market has declined. And I have a negative view on Home depot, so I definitely won’t put my money into housing-related stocks.

    11. Fred Says:

      Liquidity is king.

      1.46% return is peanuts compared to a scenario where you find a fantastic investment one year where you absolutely have the highest confidence. Let’s say, in the next 20 years, you come across a potential investment one year which can make you 100% in one year. Once in a lifetime opportunity? pretty much.
      The fact that you’ll have all your money tied up into Government-run savings programs is a huge detriment in this case, expecially if the once-in-a-lifetime return ends up being greater than 100%.

      Better to be a finicky investor, waiting for that one big opportunity, while maintaining the liquidity to actually do something about it when the time comes. With caution, inevitably comes low returns, and meanwhile the government is stealing your money using inflation every year. 1.46%? That’s no good.
      and hopefully you can come up with a winning idea more than once every 20 years.

      Maintain liquidity for opportunities, avoid government sponsored savings programs at all costs.

      $1mm doesn’t get you much these days. Unfortunately, with Uncle Sam diluting the snot out of the currency since the US went off the gold standard in the 70s, a millionaire is just a middle class goal these days.

    12. Frugal Says:

      Fred,
      I agree with most of your comments. But I don’t know any once-in-a-lifetime opportunity that will give you 100% return in a year, without the RISK of let’s say losing 50% of your money.

      Risk is always proportional to the return. That will never change. If the money liquidity dries up, and cash becomes king, the cost of capital also goes up, meaning that interest rate will go very high (so that you get paid to compensate the risk of loaning out your money).

    13. Soon to be millionaire Says:

      I thought of this strategy recently, but I am going to try it for the first time this year to see if it saves taxes: We get our annual bonus for the previous year in our first March paycheck and every year everyone is so cynical about the almost 40% that is withheld – if not more. So, I’m going to increase my 401k contribution for that particular paycheck to the maximum allowed by our plan: 80%. That will leave me with only 20% of that paycheck getting dinged with the high-end bonus taxation and 80% of the check will be in my 401k tax deferred.

    14. Frugal Says:

      Make sure you manage your cash flow properly. But it will definitely give you extra return as I have shown.

    15. cecil Says:

      Ok now that we have made changes at home depot with our CEO taking 210 million and weeded out a few others, plus we are talking about selling HD supply. I have put my money in a equity value fund witch is dodge and cox. Ans a equity growth with my company. I know that internation TEMFX is on there and it seems to be doing good, But the return is below average. So should i just stay with DODGX equity growth? it has the highest return for all my funds. I still have another year before i can roll over and invest elsewhere. I just dont trust Hd even though it is starting to shoot up a little bit. Im tired of riding the roller coaster and getting nothing in return! if you have any thoughts or know about what companies will do better in the long run, please let me know. im new to the market and just want to win! thank you….cecil

    16. Adventures In Money Making Says:

      Fred,

      why are the 100% return (regardless of the risks) considered once-in-lifetime opportunity? I’ve seen several of them in the past 4 years and have upped my network significantly because of them. (even inspite of the 2 where I lost my complete investment)

      If you look around, you can find these deals-of-a-century a few times a year.

    17. New Yorker Says:

      Fred,

      Deals of the century .. namely, perchance? :) )

    18. Frugal Says:

      Closing comments.