Second, having a cushion while you are in debt will help alleviate going further into debt. The opportunity cost of saving versus paying off debt would logically point you towards paying off debt; however, as in my first point, you need the cushion for the unexpected. The opportunity costs goes away if you incur more debt or if you cannot gain more credit and things go into collections or you must file for bankrupcy.

Third, your debt didn’t come out of thin air. More often than not, it was because of your uncontrolled spending. Breaking the habit is what is important. Integrating saving into your life is breaking your habit of spending freely. You can eventually get out of debt, but you have to also focus on post-debt life. You do this by setting up your behavior to continue once your debts are paid off.

The debt isn’t _increasing,_ however, and I believe I’ll be able to do the crazy-retirement-funding this coming year and start paying the debt down. This only works because I know that my debt, once paid down, will stay paid down, while the retirement funds will keep compounding. If I were a different person, I might well come to an entirely different conclusion.

I will continue on your use of my example

No 401K:
Taxable Income(15000-5000-3200)= 6800
Taxes = 250 + (1800*.10)= 430

1800 Contributed to 401K adjustment to AGI:
Taxable Income (15000-1800-5000-3200) = 5000
Taxes = 250

Difference in taxes(this year but you pay back when you retire) for paying 1800 into 401k:

Difference
430-250=180

Difference/401k Funding
180/1800 = 10% saved by funding the 401K

In including the SD&PE did bring it down a tax bracket, but it is the marginal rate of taxes not the average that showed the amount of savings.

Average rate do not equal what is saved in taxes for Dollar for Dollar adjustment to AGI as a eligible 401K or student loan interest.

So, someone who’s unmarried and has no dependents makes $15K gross, but only has to pay taxes on $15,000 - 8200 = 7800 of it. By your chart, that’s a tax bill of ($250 + 0.1*2800) = $530

530/$15000= 3.4%

I’ve been adhering (mostly) to Dave Ramsey’s plan — I modified it so that I continued to contribute 3% to my 401(k) to get my company’s match of 100% of the first 3%. Truth be told, I’m really disappointed in how little has accumulated in the past year and a half that I’ve been debt snowballing. Since I have another 12-18 months to go on the credit cards anyway, I decided to let it take a little longer and up the retirement. So now I’ll be contributing 9% to my 401(k), plus $300/mo to a Roth IRA. This plus the company match puts me at roughly 14-15% a month being put towards retirement. That still leaves me enough to pay extra on my credit cards — PLUS it gives me a shot at qualifying for the student loan interest deduction, which otherwise I make too much to qualify for.

I admit, it does help that my outstanding credit debt is at 0% and 3.49% respectively.

Would you put a 401K on a credit card?
That is what you are doing if you don’t pay off your CC’s (and cut them up) before you invest in a 401K.

And I would always fund a Roth up to the max, and then the 401K up to 14% (the match is a bonus in my book).

Pay off you debt and you can afford to do it!

If I had credit card debt, is it better to get a guaranteed 18% return, or a possible 8% in stocks, or a guaranteed 5% in treasury bonds? Clear choice…

What about my wife’s student loans with the New! Improved! higher interest rate (7%)? In my mind, the decision is pretty close. We’d like to have lower monthly obligations in the future so we pay off extra, with money beyond our standard monthly retirement savings.

The 4.875% mortgage rate? I get a slightly higher rate of return with treasury bills, also guaranteed, and likely higher returns with retirements savings in stocks. No rush to pay off that debt

In my view, the retirement savings should be the easiest thing to do and not a “habit” to develop. Figure out what you could possibly afford to not have, and have it put directly into a 401K, or direct investment into a Roth IRA a few days after your paycheck is deposited. Don’t give yourself the chance to choose between retirement, or those pretty blue Keen shoes over at REI.

After our debt is paid off we can completely concentrate on the 401K and savings.

I think that age could be a factor as well.

When you said you were quoting me, I think you were going to pick out this part,”The debt will get taken care of, but if I don’t start saving, I never will.”

I think it is a psychological thing. The debt will get paid because I’ve done it before, but turning myself into a saver was the bigger hurdle.

If doing one method makes you feel much better–like you can more easily sleep at night and you feel more successful and on track with your life, then your choice is easy–do the one that makes you feel better. Because all of that highest-return stuff is just so that you have more money to improve your life. If it’s easier to improve your life with a different strategy than with (a bit) more money, then that’s the right choice. I didn’t mean to imply otherwise.

My first answer was more for people who are having trouble deciding, which implies that it wouldn’t make a very big difference to them psychologically.

If you are not automaton-like, then psychological aspects should be considered. But it’s not just what makes you feel better (at least not directly). It’s still what gives you the highest return. Whatever method inspires you to scrape together the most money is probably going to have the highest real return (as opposed to whatever the highest hypothetical return would be if all scenarios were equally motivating).

Contrats man!

For example, my second mortgage is about $25K. I plan to maximize my cashflow over the next 10 months by strategically paying down certain nuisance loans and my remaining credit debt. After that, I will have a huge (to me) monthly cashflow I have to decide whether to invest or pay down more debt. But at that point paying down more debt will not increase cashflow, so I’m leaning towards putting it into a high yield savings, then when it reaches $25K in a couple years, *then* paying down that 2nd mortgage.

The obvious benefit I can think of with this plan is that money will be there for emergencies that are sure to come up in the next couple years.

I wouldn’t like to get out of the habit of putting away money for retirement, in case I forgot to start it up again. Also debts pretty much force you to repay them, either in the form of a minimum payment or a repayment schedule.

On the other hand, I wouldn’t like to have lots debt hanging over me either, I’d want to repay it quickly. So I guess I’d contribute a bit to both.

Working out which would provide the better rate of return never even occurred to me.

Not to disagree, but when making a decision based on tax rates you need to look at the marginal rate of taxes (the highest bracket of taxes paid) instead of the average rate of taxes. Here is an over simplified example.

Say you have have a $15,000 income and no deductions exemptions or anything.

Here are the tax brackets for the example.

5% on First 5,000 = $250
10% on 5,001-10,000 = $500
15% on 10,001-15,000 = $750
Total Taxes= 1,500
Average Tax rate =(1,500/15,000) =10%
Marginal Tax rate = 15%

If you contribute $5000 to a 401k you actually void paying $750 in taxes because you don’t report the last $5,000. You save 15% of what is put into a 401k no the average rate of 10%.

The home mortgage is comment is very apt. If you don’t have other things like giving, other taxes, and medical expenses to fill up the first 10K+ of Standard deductions your benefit from interest on a home loan will not be near your marginal rate.

Tax credits should not be considered as part of the marginal tax rate either because they don’t effect the benefits from a tax deduction, but credits should be sought out.

The key is if you earned one more dollar what would it be taxed at and that is what the tax savings of most deductions would be.

This may be a little bit of a tangent, but I’ve got taxes on the brain, and it’s something that I always think about when I read financial projections: the tax impact is always overstated. Whatever “tax bracket” you’re in doesn’t kick in until all the exemptions, deductions, and credits are factored out. At least for married people with a couple of kids–not an uncommon situation–that’s a pretty big chunk and the overall percentage of income due as federal income tax is way smaller than any stated “bracket percentage”.

My family’s in this situation (two earners, two kids) and I just peeked at our taxes for 2005 and 2006. Total income 2005 $56K, total taxes $2K, percentage 3.5%. Total income 2006 $61K, total taxes $2.1K, percentage 3.4%.

I recognize that the percentages can be way different for people who are single, childless, and have big incomes. (Hard for me to work up a head of steam of tax-sympathy for someone in that situation!)

The upshot of it is, putting a bunch of pre-tax income in a 401K is terrific, but the tax savings (at least in our family) are way oversold. Likewise with other “tax-advantaged” stuff, like dependent care accounts–it ends up being a big bureaucratic kerfuffle, and keeps extra money tied up til the expense is reimbursed, for a total tax advantage of what? A hundred bucks a year or so? Not. worth. it.

Ranks right up there with taking out a bigger mortgage “for the tax deduction”. Yeah, you can deduct a fraction of it–after the first $10K (for a married couple) has left your possession forever.

Pardon the rant! I’m in full-metal tax mode these days, and seeing that calculation casually tossed in always irks me.

You’re right. I’ve made a correction to the post.

What do you guys think?

If your 401k is 1 for 1 matching you get 100% return of anything you put in it and it is tax free until you retire. Unless you have a loan shark then this is the most valuable use of money if you have the cash flow to pay the requirements on your other debts.

I would also pay less on Student loans and mortgages than consumer debt because these loans have tax benefits, and they actually represent something that should keep its value.

I still haven’t decided if it is generally better to fund a Roth IRA(assuming you have a well funded 401k/403B)or pay down the mortgage. If you pay down a fixed mortgage then you still have the same monthly payments, just fewer months. Roth’s have yearly contribution caps and you can always take out principle payments and use for other things if needed.