Earn An Extra 1.45% Without Risk in 401(k) Account

This is a guest post by frugal and was originally published at 1stMillionAt33.

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:

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.