Should You Stop Funding Retirement to Focus on Debt?
Published on - October 21st, 2009 (by Adam Baker) This article is by GRS staff writer Adam Baker. In addition to his work at Get Rich Slowly, Baker blogs over at Man Vs. Debt, where he compiles the most famous and inspiring quotes on debt. This article is a part of National Save for Retirement Week, and a sort of follow-up to yesterday’s post about the choice between retirement or a down payment.
Whether you should halt your retirement contributions in order to focus debt is one of the most heavily debated dilemmas in personal finance.
Unlike “spend less than you earn” or “track every penny you spend“, there’s no cookie-cutter answer to this question. Variables such as age, career, risk tolerance, and even personality type make each individual situation unique.
You’ll never win a race against high-interest debt
Regardless of your personal situation, there are very few circumstances where high-interest debt should not be the top priority. What’s high interest? Well, that’s another fun question to debate. For the purpose of this article, we’ll assume a broad range of anything in excess of 8-12%.
Once you start trying to race against debt with double-digit interest, you’re destined to fail. It’s risky at best and downright irresponsible at worst.
Let’s be honest. If you’re still relying on high-interest debt, 99% of the time it’s a result of not living within your means. There are rare exceptions, but for most of us (myself included), the issue boils down to spending less than we earn.
On Monday, J.D. wrote about the importance of paying yourself first. Like many, I love this advice. However, I’d like to challenge you with this: Only pay yourself first if you deserve it.
You could spend decades socking away 15% for retirement, but if you are living beyond your means, you’ll still lose. You’ll be tapping your 401(k) for a hardship loan. You’ll be upside down in a house with two mortgages and a HELOC. Even with the best intentions, this is a game that you need to get very, very lucky to win.
I don’t want to rely on luck. I don’t want to race high-interest debt.
For me, having positive cash flow with at least a minor emergency fund is a prerequisite to retirement investing. This proves I deserve to pay myself first. Otherwise, it’s my high-interest debt against my retirement contributions. Not a race I’d like to see.
Ready to rumble
So now where are we?
- Positive cash flow? Check.
- Short-term savings? Check.
- Only student loans and a mortgage…what now?
Now we’re ready to debate! At this point we’ve covered the basics. We’ve plugged the leak in the ship, but still have a bunch of nasty water to bail from the hull.
Once our remaining debt has interest rates in the single digits (setting an exact percentage isn’t the point), the situation becomes less cut-and-dried. There are two schools of thought on the issue.
- The first preaches that this is the perfect time to make retirement a priority. These folks point out that starting the contributions is the hardest step. They show that the earlier we adopt this as a habit, the better our situation is in the long run.
- The second school emphasizes the power of focusing on a single goal with all your energy and passion. They profess that intensity and commitment increase the probability that we ultimately succeed in tackling our financial goals. After all, once you eliminate your debt payments, you’ll have an enormous amount of your income to allocate to wealth generation.
I have to admit, I can see both sides. Like many debatable issues, most of us are going to end up somewhere in the middle. In the quest to find balance for our own situations, there are several common factors that are beneficial to explore.
The 401(k) match
Dave Ramsey suggests going so far as turning down an employer match on 401(k) contributions for a short amount of time (fewer than 18 months) to really focus on your debt. This is where many people draw the line. Actually, that’s putting it nicely. This drives some people absolutely bonkers.
Many exclaim, “But… but.. it’s free money!” That phrase tends to be thrown around a lot. I’m not a full supporter of either side, but I would like to point out that nothing is free, folks. So please stop saying “free money”! Pretty please?
There’s a real and tangible cost to allocating your money in any specific way. There are indirect opportunity costs. There’s the risk that diluting your intensity means you stay in debt longer and thus pay more interest.
Often the math does work in favor of taking an employee match, but that doesn’t make the money “free”. Some 401(k) plans have limited investment options. Or they have vestment periods that stretch out for years. If you aren’t planning to stay with your current employer this could dwindle the value of “free” even further.
Ultimately, there are several reasons someone may decide to opt out of a matching 401(k) program for a short time. Of course, the factors at play vary drastically from employer to employer. Before making a decision either way, it’s important to know as much as you can about your particular 401(k) options.
Other factors
There are a couple other situations where investing may make sense. Consider the following:
- First, you only have a specific limit per year that you can contribute to a Roth IRA. (This is currently $5,000 per year — $6,000 per year if you’re 50 or older.) Once you miss the window of availability, you’re out of luck. Your new contributions go toward the current year’s limit. You can’t go back and make up contributions you missed for the past two years once you are out of debt.
- Second, if you don’t have the discipline to actually apply any new money to accelerate your progress on debt, then don’t halt your retirement. Decreasing your contributions only to spend the difference at the local comic books store (or your vice of choice) may be the single dumbest financial move you can make.
There’s no single answer to this dilemma. In my own life, Courtney and I have chosen to not to invest while still in debt. We live a turbulent life right now, and enjoy the benefits that come with focusing on one financial goal at a time. We’ve also decided to allocate what limited funds we do have into investing in ourselves: training, education, and building a business (our current focus).
Your situation is different. The only thing I will push you to do is consider all your options. Don’t continue making a certain decision just because it’s what you’re doing right now.
Start from a blank slate. Could you benefit from a singular focus? Are you willing to make further lifestyle cuts to increase you current contributions? Examine your options and consider the choices.
How have you attacked this dillemma in your own life?
This article is about Choices, Debt, Retirement
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We’ve very rarely carried a credit card balance, fortunately. (a month after Christmas, for example). But, while the money that companies give 401(k) participants is here now, it wouldn’t surprise me if, one day, many companies start taking away that little perk, too. Companies couldn’t afford to give every employee a pension 15-20 years ago, and it was just a matter of time before almost all companies followed suit…offering employees a 401(k) match to compensate, if they also save. My hunch is, in a few years, most companies will either reduce or eliminate employee matches, too. I’d take it while you can get it.
BTW, I’ve heard that credit card companies are eliminating rewards programs, too. We are partially funding (small percentage, but it all counts, in my book)our daughter’s college fund with a Upromise rewards program.
Life is expensive…save whatever you can, wherever you can.
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I think something’s missing from the discussion. If you are carrying debt, you have no choice about making a minimum payment. Which means that there’s a figure involved that a lot of people aren’t taking into consideration. What if, once you’ve paid off the debt, you were to take that minimum payment, and start depositing it into a Roth or IRA and earn a similar RoR to the 401K. You actually regain much of the supposed lost compounding value from the 1-2 years of not contributing to your 401K.
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My employer matches my 5% contribution 2-for-1, so I’d be turning down what amounts to a 10% raise if I didn’t take it.
Let’s hope “the market” still exists and that my investments are worth something in 30 years!
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My employer’s match far exceeds what I am paying in interest, so I continue to pay on my debt while maxing out my 401K. Once the debt is paid off I will redirect that payment amount into a Roth IRA. Like poster 53 above, I hope the market still exists and my investments are worth something in 30 years! That’s the biggest risk I’m taking.
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I get a 10% match on the 401(k). I’m no fool. I’m eating PB&J all week to fund it!
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1) For those who are not philosophically opposed to debt, it makes a lot more sense to keep those low-interest student loans with deductible interest. Chances are your home mortgage, car load etc will all cost you more in interest. You certainly should never take money from your emergency fund for that purpose. The alternative is likely credit card debt at higher interest rates and with larger minimum payments.
2) No one should be putting significant money in a regular savings account unless they are maxing out their IRA contributions for the year. If not, put your money for emergencies into a Roth IRA savings account. You can take out the principal any time you need it with no penalties. And if you don’t need it, you are on the road to saving for retirement.
3) Borrowing from future earnings is often a good idea for young people. Your future earnings are likely to be higher. Just understand how much extra it is costing you and make sure what you are buying is worth the extra cost.
There is nothing wrong with borrowing money, unless you spend it wastefully. Then it really doesn’t matter whether you borrowed it or earned it, the money was wasted.
It makes no sense to put off that trip to Europe at 22 in order to have money to take a trip to Europe when you are 82. On the other hand, how really important is that trip and are there other things you will want the money for between 22 and 82 that are more important.
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I was just wondering if someone could put these retirement articles in perspective for me. I’m not from the US so not really sure how your system works but am I right in understanding that if you personally do not ever make the choice to put any money towards retirement then when you retire you will have $0 to live off and will have to rely on government benefits?
The reason I ask is because here in Australia employers are required to place the equivalent of 9% of your pre-tax income into superannuation (an investment account of your choosing which you cannot touch until age 65)- so in a sense all employed Australians are paid 109% of their salary, they just can’t touch 9% of it yet. This way, to some extent, unless you don’t work or are nearing retirement you really don’t have to put much thought into retirement savings (other than selecting the right level of risk etc in your superannuation fund).
I was just wondering whether the savings you are talking about are in addition to what employers already contribute or whether you don’t have a mandatory system in the US?
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There is no such requirement in the US, although many employers offer retirement plans of some kind. The major source for most people’s retirement is Social Security which is a government program paid for with a payroll tax on current wage earners. Your social security benefit is loosely tied to the amount of wages you paid social security taxes on while working, but its not really a savings plan. It also provides disability insurance if you are unable to work.
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Perhaps I’m over simplifying here, but it seems pretty straight forward to me. Debt should be used or “leveraged” to your advantage. We all agree, no credit card debt, no car loans, no high interest loans of any type. But how can you say the math works to pay off other loans over saving? In my case my husband and I are 32 we have the following debt-
-13,000 school loan at 3%
-117,000 home mortgage at 6% 30 year fixed
-22,000 second mortgage at 8.35% 30 year fixed
We have investments in retirement accounts (Roth & 401Ks), a brokerage account, and savings account worth just over $215,000. Our return over the last few years have followed the market. (I’ve been investing since I was 16 so I have earned a lot and lost a lot depending on the market)
We almost max out both our Roth IRA and 401k federal limits every year. We live a frugal lifestyle to do so.
So as you can see we could easily pay off our debt. The question I struggle with is if we should reduce our 401k contribution just to the employer match and pay off that second mortgage. It might take two or three years. But I can’t get past this math-
Let’s use $10,000 for easy numbers.
Lets say I reduce our 401k savings by $10,000 to pay off part of that 2nd mortgage which rides at 8.3%- That $10,000 is actually more like 7,500 after tax. It will take me about three years and I will save roughly $35,000 of interest over the 30 year life of the loan.
Seems good right? but what if I keep that $10,000 as a contribution to my 401k and it will sit there for 30 years until I retire. Even if it grows at a measly 5%, that $10,000 will turn into 40,209.69 in 30 years. Add two more years of $10,000 at 5% for 30 years and you get another 80k. But my loan interest will never exceed the total $37k scheduled.
And my simple math doesn’t even take into consideration any tax benefits on the loan interest. Just the tax deferral on the 401k.
If my logic and math are correct then I’ve already paid for the entire interest on the second loan by saving that for just one year. Does that make sense? Am I missing something?
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Wait. I just realized that there is one other factor. If you’re not going to stay in the house for 30 years, or the entire time period of the loan, then you’ll never actually pay the entire amount of the interest. But you will still make your average return on your 401k investment over that 30 years.
I think (and please someone correct me if I’m wrong) that this proves that if the interest rate of the debt is low enough and you are young enough that you should keep the debt and fund the investments so that you can front load and take advantage of the compounding interest and time in the market.
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Wow, I am very grateful for the Australian system. As Ellen pointed out, employers here (and self employed people as well!) are required to pay 9% of your salary into what we call superannuation (i.e. retirement savings).
BTW – Ellen, you got your maths wrong, it’s not 109%, you get paid 91% of your total package and the other 9% is automatically put into savings. (9% of 109 is 9.81 both wages and super must add up to 100%).
You cannot access this money until you are at retirement age and it is only taxed at 15%. (The heighest marginal tax rate here is 49% on earnings above around $75K, so 15% is low).
Superannuation must be put into an investment vehicle, this is where you choose your asset allocation ie shares, cash etc and you have to try and make it grow (THIS IS THE HARD PART).
It’s a great system. I don’t even consider the 9% superannuation part of my pay. I’ve never seen the money in my hand and so never miss it. I actually often forget it’s a consideration for my company when they work out how much I am paid. The probably see me and think “We pay Marcella $100,000″. I feel like the company is only paying me $91,000 because I never see the superannuation they pay.
Of course, I want MORE than that when I retire, so I have also just started contributing additionally on my own too. You can do something where you contribute pre-tax dollars, so any money you put in is only taxed 15%.
I am 30, single and I have justed started paying a mortgage on my home. I was alwasy a great saver and saved $85K for a home deposit. I’ve just started putting $85 a fornight away. It’s not much, but it’s a start and I will bump that up every year. I only see a decrease in my pay packet of $48 as I am taxed in a high bracket, so I hardly notice anything. I figure it’s easy to put small amounts away over a longer period of time than try and make up for lost time.
This $85 contribution will be taxed at 15%, so I do lose part of it, but even adding that, I get $60.72 in my retirement account at a cost of $47.97 – That’s $13 free a fortnight…. If I contributed more…..
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@ Emoney – remember that after the 3 years, you’ll be able to invest the total amount of the second mortgage payment IN ADDITION to the 10k now.
So you’ll have 27 years of ‘increased’ investment and less risk from having that extra loan and payment. In addition, when you are paying off that second loan you know your rate of return, while you never do in the markets.
Being able to invest that ‘extra’ amount of the old 2nd mortgage payment is the whole point of accelerating paying it off!
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Thanks Ross Williams.
@marcella- I agree we have a much better system. Though i don’t that my maths was wrong. My job was advertised as $52000, I get paid $52000 (minus tax), the 9% my employer pays is on top of this making it 109% of the salary I actually signed up for. I guess it depends on which way you look at it.
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I have a specific time-line that I want to pay my non-mortgage debt off within, so I have reduced my retirement contribution below the maximum match amount so that I can maintain my debt-payoff goal.
If my income reduces or my expenses go up I will further reduce the retirement contribution if needed because I really want to get out of debt!
No matter what, I do want to keep a small amount flowing into retirement so that I can maintain that attitude/habit.
My guess is that the end balance in my retirement account will be less affected by my investments over the next 2 years and more affected by my pursuit to achieve financial self-sufficiency over the next 20 years.
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I think it’s important to NOT co-mingle your finances. Once you separate your finances, you can do both. There’s no reason not to.
Oh yeah, free money is free money. DEFINITELY contribute to the 401K to at least how much they match.
Good debatable topic Baker.
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i agree that people should first take care of those bad debts that make them enslaved to financial institutions because as long as they are debtors to these companies they will never be totally free to really enjoy their lives. Keep the good debts
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This post goes back to my comment on the other post and my response to this one can be summed up in one word–exactly.
“Pay yourself first” is a great concept, but only, like the author said, if you deserve it, and are in a position to do so.
If you are trying to recover from years of mismanaging your money or living beyond your means, well, it seems to me that you’ve been paying yourself first for a little too long. Might want to try paying somebody else for a change.
The person who was my mentor thorughout my journey out of financial hell used to propose the same concept to me about paying myself first. I explained to him that I would be happy to do so as soon as I felt comfortable morally, and as soon as I was able to.
Great follow up post
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I am 37 and have $130k saved for retirement. My debt is primarily car loan and mortgage. I have $25k saved for emergency fund. Because I beleive jobs are going to be harder to come by in even in the post-recovery world, I am putting off contributing to my 401K until I have $30k saved for emergencies. At that point I will get back in. I am surprised nobody has mentioned the tax savings of shielding your money from the IRS. That’s what I like about the 401k
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Hey Nicole, sounds like you are doing a great job of managing your finances, but some of your ideas sound a bit scary as you might miss out on a lot of potential growth by ignoring 401Ks for a while.
(I am assuming US 401Ks sre invested in the stock market and other places.)
If you lost money in the market craash then staying out now for a long time may mean you lose the opportuity to do some real money making and recover some loses.
Here in Australia our sharemarket has recovered 45% from 2008. There has been serious money to be made in the market in 2009. Anybody who put money back in, or left it in the market, made some serious cash or recovered a lot.
Just be careful. I’m not saying you’re wrong to concentrate on saving to some degree, but it’s always a matter of BALANCE, BALANCE, BALANCE and part of a balanced set of personal finances is having exposure to the stock market. People say they’ll get back in “when the market recovers”. No! You get in before it recovers or you don’t make any money.
The worst thing a lot of people have done is leave all their money in shares (boom times – they thought they were on a winner!), then they lost HUGE amounts of money. Then they panicked and sold when it all crashed and put it in cash, wish makes basically no interest, and haven’t had any of the upside of the market that has happened as it recovered.
Occasionally I see people on here (not you Nicole) say “They stock market is evil” or something like that and that they are only keeping cash. Those people will lose out in the end to inflation.
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My company matches 100% of my 401k contribution up to 4% of my paycheck. Is there any advantage to paying above 4%? I was contributing 11% and would like to reduce that to 4% and use the rest to pay off debt.
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I focus on debt first. Without an intense focus on paying off the debt and putting it behind you, it will linger on for years. I like the idea of making cuts in the budget, finding part-time work, if necessary, to get that debt paid off in a few years. I think that’s what Dave Ramsey suggests as well. At that point (after debt), the emergency fund will get established quicker and then onto retirement investing.
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@Iain
As a couple of us have pointed out, the math works best if you pay off the debt first, even if you do get a match. That said, it really, really, really depends on the interest you’re paying on the debt you want to pay off and your personal beliefs about debt. The higher the interest is, the bigger the long-term payoff is for paying down the debt before you put money into 401K. The match (even at 200%) and the time until retirement doesn’t matter If you are talking about the same amount of money you could be using to pay off the debt or put into 401K and when you finish with the debt you move all the $$ back toward retirement. As Adam and I point out in our examples, as long as the interest on the debt is higher than the interest you might earn on your 401K, you’re always better off paying off debt EVEN if you get a match. This is not philosophy, it’s arithmetic. You need to overlay your philosophy on the arithmetic to reach a conclusion for yourself.
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Investing in the stock market is pure speculation. The bankers manipulate the stock market so I’m not investing at all until I have the house/heloc paid for.
Every spare penny outside of contributing to EF is paying off debt first. I can then afford to gamble and lose money.
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“As Adam and I point out in our examples, as long as the interest on the debt is higher than the interest you might earn on your 401K, you’re always better off paying off debt EVEN if you get a match.”
I think this overstates it.
For one thing, many 401K plans offer the option of borrowing against them at much lower interest rates than 29%. So you can take the match and pay off your high interest loan.
The second thing is that your interest rate has to be high enough that is offsets the match. That means if you are getting a 100% match – the interest rate you are paying will need to be more than double the return on your investments.
The third issue is your marginal tax rate. If you save 25% on your taxes, that can be applied toward your loan. If your tax rate is higher, you will save even more.
If you change a few of the assumptions in the examples, the numbers will turn out quite different. You need to actually do the math – there is no rule that will tell you what works best in every situation.
If you have the financial capacity to make payments on credit card debt at 29%, you likely have the ability to get a personal loan at a much lower interest rate. The first step for anyone trying to get control over debt is to get your interest rates as low as possible. The fact that you can’t come out ahead in some situations even with a 50% match is just another example of why.
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I’ve owned a few stocks over the years that have become worthless due to not being able to keep up with their debt but I’ve never seen a company without debt go bankrupt.
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@sjb
Personally, I would hang onto the student loan debt–not pay it off AND not advance payment of it– at 3%–you get a tax break on any interest you pay so it can be even slightly less than that and it is not at all unlikely that you can earn more than 3%. There will be many investment opportunities over the course of the student loan that will earn you more than 3%.
What I would do? I would save a percentage of that in a low-risk/low-interest savings for my house and then invest a percentage in higher risk/higher return to push the total return above 3%.
FWIW, I do have a student loan at 2.675% and I don’t have ANY desire to pay it off quicker, even though I could afford to do so. There are too many other opportunities. And even if for a year or two I need to park some savings earning less than that amount, I figure having those savings gives me the mental freedom to invest other money more aggressively. The loan doesn’t weigh on my mind at all.
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We have always max. out our Roth since it became avalible. In my opinion it is the greatest retirement tool out there, Because you pay taxes now ( I hope to still have a very high continual income from real estate when I retire) and If you get in a jam you can withdraw all of your original investment with no taxes or penalties. The only personal debt besides or rentals is our house morgage which we are paying down as fast as we can while still max. our roth
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@Shane #20 – check with a credit union (college, work, parents may be members, etc). My credit union has a $50 miniumum to open a Roth!!!!
You can always roll it over later when the balance is enough to get into Fidelity or Vanguard or wherever.
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What about if you have a 401k through a former employer? Can I withdraw it or is that a bad move? At this point in time, I really need the cash. I could knock out a good portion of my debt if I could do it and pay it towards it.
What do you all think?
My debts are about 16K.
I have about 13k in a traditional 401k.
I also have about 3k in a Roth.
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O.K. there is one aspect of this arguement that people always, and I mean always, fail to mention. Actually, I’m amazed that the so called “financial gurus” never bring this up. You can’t compare rate of return on investment, verses interest rate of debt, without considering the BALANCES of each. For example if I have a $300K mortgage @ 5%, I’m paying over $1000 a month in interest. If my roth earns 7% a year, I would have to have a balance of around 200K, in the roth, to earn over $1000 per month in interest. Your mortgage interst, for most people, will far exceed what most people will earn in savings. You can’t simply say your better off paying off the highest interest rate without considering the balances of each.
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