Should You Stop Funding Retirement to Focus on Debt?

Even if the investment options are terrible, opting out of a 401(k) match makes no sense if you’re fully vested. There’s almost always a “safe” option like a money market fund, such that your return would be an immediate 100% (not counting the rate earned on the money market). I’ve never heard of a credit card charging 100% interest.

Even without a 100% match, it can still make sense to invest in an IRA or 401(k) prior to paying off debt if you qualify for the 20% or 50% Retirement Savings Contribution Credit–either of those returns (in addition to the return earned from the investments) are likely to be higher than a credit card interest rate.

Edit: The above assumes that we’re talking purely in terms of rates of return. If you find that you gain a real, valuable psychological benefit from paying off debt (or from investing), things could be different.

If the starting point is, as you say, student loans and mortgage only, I really can’t see any reason not to contribute to retirement accounts. I contributed even when “racing” with high interest debt. Because I knew that human behavior would dictate ceasing those contributions would mean that I would waste the difference, rather than increasing my payments towards debt. It’s great if you have the discipline to apply the difference towards debt, but most people do not.

As JD wrote in his article, I think you should always pay yourself first. Doing this, you will “trick” yourself into never missing that money and budgeting the remainder in a manner to pay down debts and take care of other obligations. They key is to start young before you get your first pay check. If you never see the money, you never miss it. And you can budget for the rest of your life with that money going towards your retirement.

I very much agree with Tony (above) and J.D. My husband and I had $200 deposited bi-weekly directly into a credit union savings account; we never saw that money, so we never ‘missed’ it. Then when tax time or a vacation called, we always had the money to cover it, plus some left over for emergencies. However, we wanted to finally pay off our cc’s ($1300 balance), so we quit having the money taken from the paycheck. What happened? We went on a trip to FL!!!

Keep the money from landing into that MISC. category and avoid temptation. Have your employer draw it (pre-tax, if possible) directly from your pay and deposit it into your retirement accounts, and work with what’s left to cover your living expenses. Pretty soon, you’ll have adjusted your standard of living and have a sizeable nest egg!

If we can’t say “free money” with regards to employer matching, then you can’t say “hardship loan” when talking about 401(k)s. There are hardship withdrawal options, and you are able to take a loan from your 401(k), but there is technically no such thing as a “hardship loan”. Yes, I’m being picky, but as a person who works in the financial services industry, the term “hardship loan” drives me nuts.

Tim: There’s no need for a calculator. Just compare the (after-tax) rates of return offered by paying off debt (where the rate of return = interest rate) vs. investing.

If you don’t have those numbers, then a calculator wouldn’t work either.

#2 Colin says it well. A mortgage on your home is fine, don’t worry about eliminating it prior to saving for retirement. Even a simple interest car loan may not be a bad thing. Why give the banks 14-30% interest on the credit cards and earn 3% on your savings, or maybe 10% on a risky investment where you can lose your principal.

http://www.broadcastthoughts.net/2009/05/more-bad-financial-advice.html

Overall, a good analysis. I would take great issue, however, with your statement that 99% of high interest debt comes from living beyond your means. Buying groceries, getting medical care, etc. etc. are necessities that many Americans (in Detroit, for example, there is a 29% unemployment rate!) end up having to charge.

Also, I think it would be helpful to talk more about specific interest rates. I’m all for paying student loans over 5%. But no matter how many times that Ramsey-Zealot claims I should pay off my 2.625% student loans, I can’t buy it. It’s essentially free money if you look at the stock market over the long term.

I’m a 21 year old student getting ready to graduate who is already working full time. I started my Roth IRA about a year ago and currently have a 17k student loan at 5% interest. I have chosen to fund my Roth contributions for this year before the student loan. If you look at it, given a 5% rate of return until I am eligible to retire (39 years) gives me an additional $35,0000 as opposed to taking 1 year less of contributions (38 years) and instead paying down part of my debt. That’s double the value of my loan! With patience and reasonable investing practices this is not an unattainable rate of return on my IRA. Actually, its possible to completely blow that number out of the water with a little luck.

This is a really good analysis. However, I think people can still pay into a retirement account, whether it’s a 401K, 403B, or Roth IRA, and continue paying down their debt. Of course, I’m not talking with experience here. I’m paying off debt and trying to save for a house.

Yet, the article yesterday from April, and the whole Retirement Week thing, has got me thinking that I need to start contributing, even if it’s a small amount, towards one of these choices. So, my focus will still be pay down that debt, save for the house, but put a small amount towards retirement.

Now I just have to start!

@15 James

How are you doing the math?

Given that the debt is at 5% interest, and you’re assuming a 5% rate of return, in the end, you break even. The money you earn at 5% with is negated by the 5% interest you’re charged with.

You have more money in the retirement account, but less money in the bank.

My company matches with 30% of up to 10% of my income. It’s not the best match out there, but it’s something. Let’s assume I make $1000 per paycheck (nice even number!) so 10% is $100. If I don’t contribute to my 401k, I might get $70 after taxes. If I do contribute, it’s not taxed (until retirement) so I get $130. $130 grows for 30+ years and is then taxed as I withdraw it. Or I can take the $70 and pay off some debt, but odds are I won’t be able to save $60 for every $70 I throw at debt!

@19 Steven

Its in the years of compounding the money is made. Given the fact that I intend to retire at 60 and not push retirement to 61 an extra year of contributions and a 5% rate of return nets me an additional $35,000 (632,522.63-597,402.50) assuming I contribute 5k each year, which shouldn’t be a problem.

A 17k student loan @ 5% interest that should be paid off in 3 years comes out to only $19679.625. That’s only $2679.625 in interest. I’ll taken an additional $35,000 at age 60 over saving a much smaller amount in interest now. By contributing to the Roth now I will be far better of at 60 than if I were to pay the debt off immediately and miss that year of contributions.

Personally Mr Chiots and I are do both, but we are wrestling with this as well, but not in regards to paying off high interest debt. We want to pay off our mortgage and be completely debt free. We are currently paying a double mortgage payment and still fully funding our IRA’s each year, we are on track to pay off the mortgage in 3 years, we’d love to make it 2, but that would mean lowering retirement amounts.

Another thing you have to look as is the tax savings if your retirement accounts are currently tax deductible. Taking that money that you currently pay into it could bump up your tax due come tax time.

Another reason to pay off debt is that it lowers your monthly commitments from your income. If you do happen to lose your job you won’t have as many bills to pay each month and your emergency fund will cover your expenses for longer. I choose to pay off debt because I really value peace of mind, that is worth any small amount of interest that I will be losing by not investing in retirement and paying off debt instead.

This is a great debate, and I built my own calculator to compare the 2 options. There are 2 things I did NOT build into the model: taxes or the risk associated with the investments. I could include the tax impact, but it’s really hard to quantify the risk associated with 401K investment vs. “guaranteed” return of paying down debt. That said, here’s the math:

Assume you have $5K in debt with an average rate of 12%. Assume you get a 50% match at work on your 401K and earn an 8% average return. Assume you have $400 a month to split between paying down debt and putting money into your 401K.

If you split the $400 50/50, you will have paid off the debt in ~29 months, and your 401K will have a value of $9,531.

If you go 100% toward debt and then shift the entire $400 into your 401K, over the SAME 29 month period, you will have paid off the credit card (13 months) and your 401K value will be $9,758.

So, my math (ignoring taxes) is that you’ll be a couple hundred dollars better off if you put it all toward debt. Bump the match to 100%, split up what % goes to debt v. 401K, change the rate on the 401K return or the interest on the cards, whatever you do…you’re always better off paying down the debt. The biggest lever on the outcome is the gap between the 2 rates, and the only time it actually works to put anything into the 401K is if the interest rate on the debt is lower than the rate earned in the 401K.

I’m happy to send anyone the Excel model if you post an e-mail address. I might be able to put it up in Google Docs, but not from work. Maybe someone else could add the tax effect and we could all play around with it. I agree that this would actually be a pretty useful calculator for people. When I did the math I was actually surprised by the outcome, because I was always in the “always put in enough to get the match…it’s 100% return” camp. Now I know it’s not that clear cut. To me the behavioral issue that would get most people is that if they put all the $ to pay down debt, they might not shift it all over to 401K once the debt was paid down. If you don’t do that, then all bets are off, and you’ll end up with less money than if you get going on the 401K.

OK…my actuary friend just reminded me that the other factor is the cap your company might have on their contribution. In my example, if your company would NOT pay a full $400 match in months 14-29, then you would NOT be better putting all the $$ to debt. Darn actuaries! Someone else is going to have to build that part of the model!

Writing a post arguing against saving for retirement seems counter intuitive to “National Save for Retirement Week”. All I took away from this post is that the author does not really understand how Roths work. You cannot simply compare interest to interest when dealing with retirement savings.

I paid all my debt (car loan, student loans) before starting to save for retirement or a house. Two of my four student loans had such low interest rates that I should have moved my snowball into retirement savings instead of into those last two loans. One factor is that my first job had a really good pension (though I now know not to rely on this because the rules can change at any time). Another factor is I was afraid of the market back then. I started by contributing an amount I could afford to lose.

Then I got sick of everyone whining about losing half their money when they had just doubled it three or four times. So when the Roth IRA was invented while income taxes were at their lowest in years, I decided to max that. And now I fund retirement at the same time as I’m paying off my mortgage. My mortgage interest rate, at 6.625%, is near historic lows, nothing like the 18% my parents were paying.

In my case, I suspect that starting with a single-goal strategy helped me get the good frugal habits I have today that help me juggle multiple goals. And I really like being able to save for house repairs and my next car while also spending guilt-free from my vacation savings, so I’m a big fan of the multiple-goal strategy.

That said, I will be really glad when my mortgage is paid off and I continue re-evaluating whether to prepay. I also am planning to do some renovations and plan to pay as I go rather than take out loans.

@Tim, it’s mostly about the interest rate of your loans compared to the earnings you would receive from your investments. Unfortunately, you never know what your investment earnings will be during the time you’re making minimum payments on your loans. No one even knows the average—they used to say the average stock market return was 11%, and now they’re saying 8%. Either way, that sounds better than a 5% student loan but worse than an 18% credit card balance. Another factor is if you’re rich enough to more than max out your contributions, then you will regret not having made some of those contributions earlier and using your extra money to pay off debt now. I was never in that position. $5000 IRA + $15,000 403(b) used to equal or exceed my entire take-home pay.

@Michael #12 – I disagree with Walter. In your shoes I’d look for a way to earn or save $50 extra per month to throw at the more expensive student loan and start your snowball. Or plan to add your next raise to those payments. It’s amazing what even a small addition can do.

@Kevin M – hedge yourself by putting money into both the mortgage and the IRA. The stock market has already been a lot higher than it is now, but people are still saying that the prices are no longer at bargain levels, so I really have no feel for where it’s headed next. Personally, I think of the Roth IRA as a great hedge against tax increases. With all the debt the US is acquiring not to mention the Social Security/Medicare funding problems, tax rates are going nowhere but up. Pay your taxes now, and when the brackets move back to where they were in the 70’s, you’ll be so glad you did. Another strategy is to look at your stock/bond ratio, and put the money you would normally put into bonds (safe, reliable, low-interest vehicles) into your mortgage (a different safe, reliable, probably not-quite-so-low-interest vehicle).

@James – I want to point out that for every month early that you pay off your mortgage, you have an extra month that you can contribute your current principal and interest payment to your retirement fund, so that complicates things a bit. Still by paying into your Roth over more years, you’re reducing the risk that you will buy all your investments when they are expensive.

@Debbie,

The issue is the contribution limit with a Roth. I agree in regards to a 401k. But for a Roth, you can’t go back in time and contribute for a missed year. A missed year factors heavily into a long-term compounded fund.

Seems like most of the posters have forgotten to account for age in this argument. Ideally everyone would contribute to their 401k to at least get their companies matching amount. However if someone is seriously considering passing up contributing they should keep in mind the effects of compounding interest. Its more costly for someone in their early twenties to pass up contributing to their 401k in order to pay down debt than it is for someone in their late 40s and early 50s.

A large number of you have brought up the argument that funding should be directed towards retirement to take advantage of longer periods of compound interest.

Y’all are forgetting the debt is subject to compound interest as well and the longer you take to pay it off the more you will eventually pay.

The choice all comes down to effective interest rates. If the effective rate(not estimated) on retirement is higher than the rate on debt, save. If the rate you are paying on the debt is greater than what you could get for your savings, pay off the debt.

We continued to fund our 401ks even when we were paying off $55,000+ in debt using Dave Ramsey’s snowball method and working his baby steps. We figured out that we could do both, pay off our debt and fund our 401k if we lived off of rice and beans for a year, it took us a bit more than a year but we did it.

I think it can make sense to suspend or reduce retirement savings while focusing on debt assuming that you are really, really focusing on paying off debt. If you continue to live a regular life, not a rice and beans life, and chip slowly away and debt while foregoing savings (retirement or otherwise) this makes no sense to me. But if you’ve got a plan and focus then I agree with focusing all energy and money on killing debt (which for me is all debt except mortgage).

I don’t profess to know the answer to how to beat debt quickly. But for anyone with bad debt that isn’t productive such as a more expensive car the first thing I would suggest doing is selling that car, even at a loss, and paying as much of that debt back now. If you’re set to lose $3000 now on a $50000 car its going to be much less than the interest you pay on it throughout the loans lifetime.

Than go out and buy a more reasonable car, I recommend used. I have seen nice CRVs for $6000 cash online. If you think cars in the $6000 category are beyond your taste than look at yourself and ask why you’re always stressed about debt. The answer will be more clear.

@37 Broadcast Thoughts-

Yes the interest on the loan compounds as well. However here’s the kicker, the contribution to the Roth will compound over 39 periods in my case (39 years till retirement). The interest on the loan will only compound for 3 years, 5-10 at most if something goes really wrong. In compounding periods that is a HUGE difference.

@40 Beth-
I’m glad I started now. I’m studying finance at school and the goal is to become a CFP/CFA eventually. Figured it best I follow the advice that I would give to someone else. I just wish I could convince some of my friends to become more financially responsible. One of my buddies has over 100k in student loans through Ohio State University. Its crazy!

I ran some numbers the other day, and in the long run it depends almost entirely on interest rate. If the interest you pay on your loans is higher than the interest you’ll get on your retirement money, it’s better to focus on your loans.

It seems as though “paying yourself first” has more to do with psychology than it being the best choice financially. If you can honestly trust yourself to save your money, chances are you’ll have more money in the end if you pay off your debt first. That’s a big If, though.

I have always invested modestly in my 403(b) plan — just a bit more than I needed to put in to get the max match. I figured that in my twenties was a time when putting *anything* in would do me a lot of good later.

My general rule is that for very low interest debts (less than 3% interest), there’s not enough incentive for me to pay them off quickly; instead of pushing on those, I put money towards my emergency fund. When it’s fully-funded, that money will go towards an IRA. The exception is a family loan, which I am motivated to pay off quickly for emotional reasons, not financial ones.

@ Debbie # 31,

From a mathemetical standpoint, you may be correct; however, Michael’s issue is more psychological than mathematical. He obviously feels that to stop contributing to the Roth will cost him investment opportunities. Sometimes setting your mind at ease is more important than the numbers can dictate.