How to Use a Windfall to Supercharge Your 401(k)

There are a number of different reasons why you might suddenly find yourself with some extra money:

Tax refund
Bonus
Cash gift
Employee stock vesting (which you should often quickly sell out of)
Inheritance

There are a lot of good things you could do that with money, and using it to turbocharge your retirement savings is certainly on that list. After all, your savings rate is the single most important part of your investment plan and anything you can do to increase it is worth some consideration.

And while you can’t directly contribute cash to your 401(k) – since contributions have to come out of your paycheck – there is a way to use that windfall to increase your 401(k) contributions without impacting your monthly budget. Here’s how to do it.

Meet Chloe

To show how this works, we’ll use Chloe as our example.

Chloe makes $60,000 per year and contributes 5% of her income to her 401(k). Since she’s paid twice per month, she ends up contributing $125 per paycheck. That’s $3,000 per year, which means that she has plenty of room to increase her contributions before she hits the $18,500 annual limit for 2018.

Chloe also has an incredibly generous grandparent who just gave her $4,000 for her birthday. Since she already has an emergency fund and her other short-term goals are on track, she wants to put this money away for retirement.

She could contribute it to an IRA, but she’s lucky enough to have a good 401(k) with even better, lower-cost investment options than what she could access on her own. So she’d like to put the money there if she can.

Here are the four steps she takes to do just that.

Step #1: Put the Windfall in a Separate Savings Account

First, she puts the money in a separate savings account. She wants it to be easily accessible, but she doesn’t want it mixed in with her day-to-day spending money or even her other savings that might be used in the near future for other goals.

Keeping it separate allows her to know that it will definitely be there when she needs it.

Step #2: Increase Her 401(k) Contributions

Chloe has 16 more paychecks the rest of the year and a $4,000 windfall, which means that she can contribute an additional $250 per paycheck. Including her current $125 contribution, that’s a total of $375 per paycheck for the rest of the year.

Given that her per-paycheck income is $2,500 – calculated as $60,000 divided by 24 – she needs to increase her 401(k) contribution to 15%. With that increased rate, she’ll end up contributing exactly $4,000 extra over the rest of the year.

Quick note: One thing to keep in mind here is that you need to stay within the annual 401(k) contribution limit, which is $18,500 for 2018 (or $24,500 if you’re age 50+). If Chloe had received a $20,000 gift instead of a $4,000 gift, she wouldn’t be able to use the entire gift this year since it would have put her over that limit.

Step #3: Calculate the Difference in Net Pay on Her Next Paycheck

With that change in place, Chloe is now contributing an extra $250 to her 401(k) every time she’s paid. But that doesn’t mean that she’s receiving $250 less than she used to.

Since 401(k) contributions are tax-deductible, that extra $250 will reduce her tax withholding, leading to a smaller difference in net pay.

Assuming that Chloe is in the 22% tax bracket, her net pay would only decrease by $195 per paycheck. Or to say it another way, Chloe will have $390 less than she used to have for her other monthly needs because of the increased contribution.

Step #4: Withdraw That Amount from Her Savings Account Each Time She’s Paid

This is where Chloe finally gets to use that $4,000.

Every time Chloe is paid from now until the end of the year, she can move $195 from her separate savings account to her main checking account. She can even set up automatic transactions between those accounts so that she never has to think about it past the initial setup.

With that in place, Chloe has ensured that she has the exact same amount of money to spend each month as she did before she increased her 401(k) contributions. She has indirectly transferred the $4,000 gift into her 401(k) without affecting her monthly budget at all.

Bonus Step #5: Figure out What to Do with the Extra Money

If you’re following along closely, you’ve probably already noticed that Chloe will have some money leftover in that separate savings account at the end of the year.

$195 over 16 paychecks adds up to $3,120, which means that she’ll still have an extra $880, which represents the tax savings from those 401(k) contributions.

At this point, she can do whatever she’d like with that extra money. She could keep her 401(k) contributions higher for a little longer. She could pay off debt. She could plan a vacation. Or she could put it towards another goal.

Get Creative with Your Windfall

In some ways, using a windfall to increase your 401(k) contributions is the best of all worlds. You get to turbocharge your retirement savings AND you receive a tax break that can help you make progress toward other goals at the same time.

It’s a win-win, and all it takes is a little creativity and some simple logistics.

Matt Becker, CFP® is a fee-only financial planner and the founder of Mom and Dad Money, where he helps new parents take control of their money so they can take care of their families.

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