8

Should I Contribute to a 401(k) or Pay Off Debt?

Posted October 6th, 2011 in Debt, Investing by Jeremy Waller

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  • Tax deferred growth: Money in a 401(k) is not taxed until it is withdrawn.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:

  1. Take full advantage of any matching your employer offers.
  2. Pay off all of your debt except for your house.
  3. Save for retirement
  4. 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!

Like what you read?
If so, get weekly personal finance and wealth building tips (that you can't find on the blog!) and get a FREE COPY of my eBook, 25 Essential Lessons on Money! Just enter your name and email below:

8 Responses so far.

  1. I recently had to think about this myself and decided to go with the match. I didn’t run such a sophisticated set of numbers like you did, but figured where else will I get a 100% return on my money. Our new match is dollar for dollar.

  2. Great read. I love that you broke down the math with the employer matching. Keep the good posts coming.

  3. Ed says:

    I have been putting in 5% of my salary in my retirement plan, which is matched. Now, I have $121K in the account. I am able to borrow $49K from it, paying myself back at 1.5% interest over 5 years. I was thinking that I would pay off a home equity line of credit and my credit cards with this, in order to save the interest. Would this make more sense than leaving the money in the account to grow?

    • Jeremy says:

      Hi Ed,

      There are a number of reasons I would advise against a 401(k) loan. Here are the 2 biggest ones:

      1) Your true cost of funds is more than 1.5%. Not only do you pay interest, you also miss out on any gains you would have realized on those funds. If your 401(k) is averaging 7% returns then your loan would actually cost you 8.5%.

      2) If you leave your job (voluntarily or not) the outstanding balance is due immediately. If you can’t repay the loan it is treated like a distribution which incurs a 10% penalty, plus you would have to pay taxes on the distribution.

      • Ed says:

        I’ve thought about these issues. The problem is, I have to pay off the home equity because I’m going through a divorce. I have no plans to leave my current job, and I will do my best to be indispensable to my institution. The 1.5% goes back into the account, so it is just the opportunity cost. On the other hand, I’m paying way too much in interest on the line of credit and the credit cards. I may be able to pay it off faster, once things stabilize. I could just take out enough to cover the home equity loan.

        • I’m sorry to hear about your divorce. You may not have many options then. Would it be possible to structure the divorce settlement so that you would not have to pay off the HELOC? I’m just not a fan of taking out a loan to pay off other debt. 401(k) loans aren’t evil, but I think they are dangerous. If everything goes according to plan, the numbers work. But if something unexpected happens where you are unable to repay the loan, it can end up costing you far more in the long run.

Leave a Reply





Read previous post:
bank-of-america
Everyone Is Wrong About Bank Of America’s Debit Card Fee

Everyone is up in arms right now because of Bank of America’s announcement that it is going to start charging...

Close