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Yes. The 457(b) plan I contribute to does the same thing. It is perfectally legal as well. It is the same as depositing money in a bank and they hold it for a day or until the next business day without crediting your account and letting it accure interest.
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The example you give here seems a little different than the scenario I'm talking about. You say that a bank can hold the money for a day or so without depositing it, so for that time you wouldn't earn any interest until the money is actually in your account. But that's it, I myself, simply don't earn interest until it's there.
In this case, though, the employer is earning an interest return on everybody else's money until they deposit it into everybody's accounts. That's like if I was the middle-man on somebody else's 401k. They give me THEIR money, which I put into my own bank account for half a month, during which time I'm making money off of THEIR money before actually depositing it into their own account.
That just seems wrong to me. I'm new to it all, so that's why I'm asking, but it just seems like they're smoking us for that extra interest. We have about 350 employees here, most of which put money into this 401k. So if 300 people are putting approximately 5% of their checks into the 401k each week, and that money actually sits in the employer's bank account instead of going directly into our 401k accounts, the employer is making money off OUR money.
That's our hard earned money that we're putting aside for OUR benefit. Why should the employer be able to earn interest that we ourselves could earn if the money was in our own account the whole time?