Ah, the two biggest issues in the works of personal finance – saving for retirement and paying off debt. Both are incredibly important goals. Both usually take a significant amount of time and money. But which one is more important. Should 401(k) contributions take precedence over paying off debt?
First, it’s important to think about why you contribute to a 401(k) in the first place.
A 401k has a number of advantages over a vanilla investment account:
- Tax breaks: 401k contributions are on a pre-tax basis. That means taxes are calculated on your earnings after deducting your 401(k) contribution.
- Tax deferred growth: Money in a 401(k) is not taxed until it is withdrawn.
- Employer matching: Many employers offer some type of matching on contributions you make. For instance, they may match 100% of your contributions up to 3% of your salary. That’s free money right there. If you don’t contribute to your 401(k) then you don’t get the money.
Great benefits – not something that you want to miss out on. But, are those benefits strong enough to outweigh the burden of debt?
In almost all cases the answer is yes and no.
There is one part of a 401(k) that I would never want to miss out on, unless I had no other choice – the free money part.
If you have an employer-sponsored 401(k) with matching you should take advantage of it! My employer matches 50% of contributions up to 6% of my annual salary.
Making between $50,000 and $100,000, that would amount to an extra $1,500 – $3,000 per year.
The only time this wouldn’t make sense is if you were carrying debt with a very high interest rate.
Let’s Run Some Numbers
Let’s say you have the choice of either contributing $5,000 to your 401(k) or paying off a credit card with a $5,000 balance.
Let’s assume that your employer will match 50% of your contribution – giving you an extra $2,500. To make it easy, we’ll also say the market isn’t doing real great and you see no growth on your investments this year.
Let’s also assume that Visa is screwing you with a 22% interest rate.
Holy smokes! Contributing to your 401(k) wins by a landslide.
The only way it makes more since to pay down debt is if it carries an interest rate of 85.2% or you expect a loss of 67.9% on your portfolio this year!
You would be insane to not take advantage of employer matching.
What If My Employer Doesn’t Match My Contributions?
Now that a whole ‘nother ball of wax.
If your employer doesn’t match, then that removes that component in the analysis above that makes the whole thing work.
Without matching, you would have to have a very special set of circumstances for it to make sense to contribute to retirement while you’re still drowning in debt.
In this case, my advise is to pay off all of your debt except for your house – then start putting money away for retirement.
You are fighting a losing battle if your are trying to save for retirement while interest is building on credit cards, lines of credit, and any other consumer debt you have.
The Bottom Line
Here’s what it boils down to:
- Take full advantage of any matching your employer offers.
- Pay off all of your debt except for your house.
- Save for retirement
- If your employer doesn’t offer matching, skip step number one.
I think that’s a pretty fantastic plan. What do you think? Agree? Disagree? Let me know in the comments below!