by Tricia
This year will be the first time I will have the opportunity to participate in a 401(k) plan at work. My company does not offer matching funds. If they offered an employer match, the decision would have been easier. The match is esentially free money and I should take advantage of that even if I have a mountain of debt still looming.
But, the match is not there. Should I continue to pay off debt or pay into the 401(k) plan?
Doing a quick search on Google yielded articles that said I should contribute if there is a company match. There was little that I could find that mentioned the benefits of contributing to a 401(k) when there is no employer match present.
So, I’ve decided to pose the question to the personal finance bloggers at the Money Blog Network Forums.
“I will be turning 30 shortly and I have $24,000 in credit card debt which I am hoping to have paid off by May of 2009 with an aggressive debt reduction plan. As for current savings, I have a grand total of $121.00 in a savings account.
I have the option of participating in a 401K plan for the first time in my life and I am not sure whether to forgo the 401K for now and keep paying off debt or to contribute to the 401K. If my company was giving matching funds, I wouldn’t think twice…I’d contribute to the 401K because I would be getting free money. BUT – there are NO matching funds.
Given our situation, and the lack of the “free money” incentive provided by an employer match, I don’t think I should contribute. I think I should stay focused on paying off our debt aggressively and once it is paid off focus on saving.
I know retirement is important to plan for, but to lock that money away doesn’t seem like a good option at the moment. I just wrote an article about survival debt it made me realize how little it would take for us to have to go back to living that way.
Should we be stashing money away for the future when there is such an unstable present due to bad debt?”
So far, I have received some interesting thoughts.
I’d also like to ask you if you have any words of wisdom that you would like to share. I’m all ears 🙂
I don’t receive a match either until after a year of being employed. Therefore I am only contributing 3% until I can get my debt paid off. It’s like contributing to a savings acct tax free and you’ll be glad you contributed before you were debt free once it starts growing. So my suggestion is just do a small percentage and then perhaps cut out another expense in your budget.
I have a similar dilemma as you. But more so along the lines of should I contribute to a 403b with no matching funds or to a Roth IRA. I am no where near the max contribution levels to either one (I’m talking maybe $50 per month to contribute to either).
I read somewhere (can’t remember, sorry) that a person should contribute to their 401k up to the company match, than do the Roth, than go back to the 401k and contribute to the max allowed amount. Obviously, a person would figure out the dollars in the beginning so they weren’t constantly juggling the money.
So, relating that to our situation, I would take out the first 401k contribution and take it from there. Currently, I contribute $50 per month into the 403b, but I think I am going to stop that and start up with the Roth.
Sorry for the long comment, but let me know what you think.
I recently watched Suze Orman’s ‘Young, Broke, and Fabulous’ DVD. She commented that you should only contribute up to what your employer matches in the 401k (since yours doesn’t, I would say move on to these next points). Next, pay off your credit card debt, and if you still have money to invest, put it into a Roth IRA. The advantage of the Roth over the 401k is that if you have to withdrawal money from the 401k, you will be taxed (possibly at a high tax rate, unsure since you can’t fortell the future), whereas with the Roth you could withdrawal anything up to the original amount if needed (excluding interest earned), and the money is already taxed.
I wrote virtually the same entry over on my blog. We’re sitting at $58k worth of debt, and I’m torn between what to do, with regards to saving for retirement or concentrating on paying down debt. I’ll be interested to see the responses.
I am in the same position. I am going to increase my automatic transfer into savings and max out a Roth IRA.
Bummer about the match 🙁
If there’s no match, then the next question is will the tax benefit be worth it to you to contribute anyway? To help play around with the numbers, check out the calculators at http://www.dinkytown.com/taxes.html . In some of them you can enter the different deductions from your pay – pre and post-tax, and see an estimate of your take home pay.
I don’t know a whole lot about how taxes and witholding are calculated, but you could end up with a little more in your paycheck because less tax is being withheld. Or you could end up with a slightly smaller paycheck but a much smaller tax bill in April 2008.
Another thing to consider is your 401(k) savings could double as your total disaster fund. You can take out your 401(k) savings penalty free if you have a hardship – but you should definitely check what those hardships are before you decide to consider the 401(k) as backup emergency fund. I think one of the cases is if you are in danger of losing your home due to a medical emergency and you’ve exhausted all other resources. Since you’ve grappeld with whether to start an emergency fund or not, this might be a small way to start both retirement savings and emergency savings in one step. Then, of course, once you’re debt free, you can consider your 401(k) as only retirement and start your emergency fund 🙂
Another question to consider is the likely return rate on the 401(k) savings versus the credit card debt. Depending on your age, how much risk you’re willing to take in your long-term investments, you could have a 401(k) fund that’s mostly stocks. In this case, your return rate could be high – 8-12%, which may or may not be higher than the interest rates on your credit cards. However, you cannot predict how well the stock market and mutual funds will do. But, rate of return versus credit card rate is something to consider.
How often can you change your contribution amount? You could have 2-3% taken out for a month or so, and if you miss the money, you can stop contributing. Or, if you find it isn’t hurting you a lot, you could increase your contribution.
I agree with the first poster. Contribute 2-3% so you get in the habit of contributing and then once your debt is paid off you can up it. 2% of a $50,000 salary is only $1000/year, or $20/week from your check.
I’d be afraid that if you don’t start contributing something, you will be waaaayy behind by the time you get around to it after your debt is paid off.
I look at it this way: I expect that my investments will return 8% on average over the next 30 years. So if I have interest higher than that (say that 9.9% credit card), I’m better off paying that off. If I have interest lower than that (the 0% one), I’m better off taking the 8% in the market.
Here’s an article that discusses what seems to be your exact situation.
I started contributing to my 401(k) plan as soon as I was able. Even though my employer doesn’t match a dime. Of course, I wasn’t trying to pay down debt either. I started out at 5% and just left it at that. Someone mentioned that when I get a raise I should increase my 401(k) by at least 1% so I did that faithfully until it reached 8%. Then I just left it. We had some rough times and didn’t get raises, etc.
Anyway, now I’m on this get out of debt kick and have been told I should stop contributing all together. Personally, I don’t like that idea because I like the habit of contributing. So what I did do was reduce by 5% so now I’m down to 3%. Yes, my balance in my account is now high enough after years of contributing that I could probably leave it alone and it will still continue to grow, but I just don’t like the idea of doing that.
I would say contribute as little as possible in the beginning, like they’ve said in prior posts, 3%. Just to form the habit and become accustomed to how it works. That’s just my two cents. 🙂
By the rule-of-thumb on retirement contributions, since there’s no company match you should consider a Roth IRA contribution instead of a 401k contribution.
But rules of thumb are just that — everyone’s different. But if you contribute to a retirement plan, you may indeed want to make a Roth your first choice. If you are in a low tax bracket now and expect to be in a higher tax bracket later on. If your 401k plan offers lousy investment options, such as mutual funds with high fees.
Also review the rules on the irs.gov website — I believe you can access the contributions to a Roth IRA without penalty (but not earnings). If so it could back up your emergency fund.
Because of the nature of compound interest, I would put a little in your 401k regardless of your debt, even if it is only 1%. Also, I have found that mentally, it is easier to increase your contribution than to start the contribution.
We have a 403b where I work and this company doubles whatever we put in up to a certain percentage. You don’t see this very often. We keep thinking that eventually they will stop so we put in the most at this time. As far as your question goes. Yes, start small but start something. 5 – 10 years from now you will be glad you did.
If you really believe you’re one setback away from falling into survival debt, I think a small contribution to an emergency fund in a high-yield savings account would be better. That way, you would have much better access to that money, should you need it. And if you never end up needing it, or much of it, after a year or two, you could start moving it to a retirement account.
Thank you…thank you everyone! There are many great points here as well as on the forum. I am still in the process of reading through the paperwork and learning more about how 401k’s work so I feel comfortable with them. I think deep down that I do have concern that the money put in could shrink or disappear (as in the case of one gentleman lately). I need to decide soon, and I will let everyone know what happens.
Just another quick thought on Roth IRA’s… Yes, you can take out what you put in w/o penalties, but I believe you have to wait 5 years to be able to do so. Also, I don’t know if you can get a Roth from a bank. Most low cost mutual fund companies like Vanguard and Fidelity have minimum investment requirements for their funds. Vanguard’s is usually $3,000. A 401(k) has no minimum 🙂
But, as one poster mentioned, your company’s 401(k) may have lousy investment options. Or it might not. So you might want to check out websites with retirement investment info to get an idea of what type of asset allocation you should have, along with what are acceptable expense ratios for mutual funds. You could also check out some books from the library – Personal Finance for Dummies would be a good, basic book. Also, the book by Jane Bryant Quinn would be good (I can’t remember the title).
If I didn’t know you, I’d say go for the 401K. Simply because you might falter at paying down the debt. However, reading your blog, I know you are serious about paying down debt, so I’d say keep doing what you are doing.
The only real factor to consider is the tax consequences. I’d say if your income will be going up quite a bit, then it would be nice to put that money away in a 401K to avoid taxes. However, if that were the case, then you’d have money to do a 401K and pay down debt.
As I read the rules on Roth IRAs at the IRS website http://www.irs.gov/publications/p590/ch02.html#d0e9988, the 10% penalty is applied only to the taxable portion of a distribution. Since the contributions are distributed first they are not subject to tax and penalty.
Now if you’ve done a conversion from a traditional IRA to a Roth, those amounts are subject to penalty if distributed within 5 years of the conversion.
Recommend that you consider the Roth, but if you do so read the IRS publication I linked and decide for yourself.
One issue for withdrawing the contribution portion of a Roth IRA is that the remaining balance may be too small for the IRA trustee to want to maintain it, so I’d check that aspect out with the trustee before opening a Roth IRA if you think there’s a significant chance of needing to access the money. But the penalties and taxes would apply just to the earnings. Again, this would be a backup to an existing emergency fund, at least the $1000 minimum in liquid assets that Dave Ramsey recommends.
Before contributing to a retirement account, whether a 401k or a Roth your debt reduction snowball should have developed momentum and should not be stopped by the retirement account contribution. Appears that in your case you could contribute some amount, if not the maximum allowable.
Although the interest rate on your CC debt is probably higher that what you can get from your retirement account, there is still the opportunity cost to consider. If you don’t make this year’s contribution by the tax filing deadline, you don’t get to make it at a later date. Your retirement account should be in place for decades, if you continue to aggressively hack away at your CC debt it should be gone in a few years.
I agree with the posters who think you should fund a retirement account but make it doubel as emergency savings. For this a Roth IRA will be better, you can withdraw contributions any time (not after 5 years) and many institutions have very low minimums for automatic investment programmes. For example, ING recently started offering IRAs and you only need $25 per month.
Congrats on your plan. Investing some amount in a 401k matters more than pouring all your money into debt. First, lenders like to see that history of saving through a 401k. 401ks are a indicator that you are taking responsibility for your funds. It’s also a means to borrow against I don’t recommend), which translate into a repayment source for them if necessary. Second, time is on your side. Compounding interest tax deferred in a retirment account is free money and the money stays with you. Third, you’re automatically building your net worth. Lastly, it gives you something to count on for retirement and emergencies. So your real question should probably be how much to contribute.
Max out individual retirement accounts first. You’ll have a better selection of low-fee index funds, and IRAs are more flexable about loans/special withdrawls.
Your non-matched 401k is really only a good bet if you can’t get tax-defferred money put away any other way.
As far as debt v. retirement: Invest in the retirement now. You’ll reduce your consumption to pay off the debt, and the funds invested in your retirement will grow. Every year you delay saving for retirement, you miss out on a HUGE pile of returns via compund interest.
You can’t compare your CC APR to your investment return.
You have to make the payments on the CC, so you’ll reduce consumption to do so.
You *don’t* have to make the deposits into the retirement account, so you’ll instead consume the money.
Reduce your consumption and do both.
–Michael
Michael some good points above. To that I’ll add this:
In the long haul, I think you’re better off putting money into your 401(k).
I was thinking about this last night, and it occurred to me that if you factor in that your 401(k) earnings are tax free, and assuming you’re 30 or more years away from retirement, odds are at retirement, you will have earned more money on the 401(k) contributions than you would have saved in interest on your credit cards.
Short-term, yes, it could delay your credit card payoff date. BUT, I would suspect only by a few months.
I’m an occasional visitor, found your site looking for prosper.com info. I believe your choice ultimately depends on the interest you’re currently paying on your debt. If it’s 20%, then it’s a no brainer, I’d say don’t put a penny into a 401k. Without a company match Roth IRAs are the ideal place to put that money away. In fact I’ve read (fool.com) that even after company matched 401k contributions and maxing out your Roth, individual investments are preferred over a 401k.
If your interest rate isn’t that bad (~10%, rough guess) put some retirement money in a Roth IRA. If you suddenly need some money, as someone mentioned before, you can withdraw your contributions penalty free.
Jen: Your 401k earnings are NOT TAX FREE!!!!! They’re just tax-deferred. Meaning you’ll have to treat them as income when you withdraw them and pay any applicable taxes at that time.
OTOH, you may have the correct point of view about the 401k earnings long term overcoming the credit card interest if paid off soon.
I don’t think there is any one-size-fits-all answer to this one. I am impressed by your commitment to paying down your debt and I think that the amount you paid down in 2006 speaks for itself. When it comes to finances, every decision is a personal one and I think you should do what you feel most comfortable with. Some people like to contribute to an emergency fund first, other people like to pay off debt; even in paying off debt some people prefer to pay off high interest debt first while others like the psychological effects of the “debt snowball.”
The problem with retirement accounts is that while mathematically it may make more sense to pay down debt first, without money in your retirement accounts collecting interest, you may have to end up delaying retirement if you don’t contribute sooner than later because the field isn’t level — retirement accounts have maximum annual contribution limits that make it difficult to catch up if you wait until later to begin contributions.
If you do decide to contribute to a retirement account, I’d say forget your 401(k) and contribute to a Roth IRA. With an annual income of $47,000 and tax rates being as low as they are (when viewed in a historical context) It doesn’t make sense for you to defer your (relatively low) taxes now when it is likely that you’ll be making more money and that taxes will be higher when you are getting ready to retire. Additionally, since you are aggresively paying off your debt, I doubt that you would be looking to put more than the 2007 IRA limit of $4000 towards retirement this year anyway. Plus, 401(k)s often have limited funds to select from and high maintenance fees.
Someone above did mention the investment minimums for companies like vanguard and fidelity, however, I think T.Row Price has a minimum starting investment of $50 if you make regular contributions over the year, which could be an excellent way to get started!
All this being said, personally I’d still pay off the debt. You are on a roll and I think that the momentum that you’ve built up is really great! I’d hate to see you slow down because you have less money to commit to debt, even if that money is going into retirement savings.
Once you are out of debt, you are going to feel like you have more money than you know what to do with! Just think of the retirement savings contributions you can make in 2010 when you’ve eliminated your debt!
Good luck!
EMF: Yes, I know that technically the earnings and contributions are tax deferred. I was thinking more in terms that before you retire or have to start taking withdrawals, the money is earning returns tax free – you don’t have to pay taxes on the returns before you retire. That’s why I said the earnings are tax free – I was only thinking about the pre-retirement period.
And, even though in retirement you have to pay taxes on what you withdraw, the principal and accumulated earnings left in the 401(k)/traditional IRA are still earning returns that are tax deferred.
I haven’t figured out the math behind, and even if I did I’m not sure I’d want to do all the calculations, but I have a feeling that not paying tax on your earnings for thirty years will yield more $$ in the end than paying taxes on the earnings each year, simply because the gains get re-invested and earn more money.
I’m impressed by the progress you’ve made paying down this debt!! Way to go!
As for the 401 question, my suggestion is to start with 1 or 2 per cent and continue paying down as you are now. In a couple years when you are debt free you’ll have the habit of contributing and you’ll have a lot more available for catch up contributions.
I think that you should stay the course and pay off all your credit card debt first before venturing into your 401k[non-matching] or a Roth IRA.The more money you concentrate on paying off the credit card the sooner you will be free, mostly the intention of your blog. You are young enough to be saving in earnest when that hideous 13% rate is gone, and it will be shortly.Stay the current course and keep focused. A rainy day fund should not be invested in this current market for the short term.If you stay with your current plan your debt will be gone in the short term.For future thought, a Roth would be a better long term investment than a non-matching 401 k. I admire your resolve.
Why would anyone begin making retirement contributions before paying off debt?
If your debt interest rate is higher than the 401(k) rate ( which you have no idea what your return will be ) you are borrowing money at a high rate (10-18%) and investing at a low rate (???%), thus guaranteeing yourself a loss every year that you do it. That is a great way to go bankrupt.
My opinion is forget the 401k. Personally, I think 401k’s are over-rated. Your money is tied up until retirement. Of course you can take a loan out on your 401k, but that can become a big headache. A lot of people are tempted to cash out their 401k, when they leave there employer. Money in the 401k is usually invested in stocks and bonds. This money isn’t insured! It fluctates, your debt always grows. Also money in 401k’s usually come with a “maintenance fee” of like 1%. My plan is attack debt, and kill it. All debt is evil. Once debt is gone then you can invest in retirement.
I would say don’t do the 401K pay off the debt fast! I read The Total Money Makeover by Dave Ramsey and it makes so much sense! When my husband got laid off we had no debt but no savings. 18 months later – lots of debt!
We started as the book says and stashed $1000 as fast as possible for an emergency fund. Then we paid off everything else except our car loan and mortgages. This varies from his program because he says to pay off the car loan. We even stopped contributing to the 401K so we can save faster as the book suggests.
Our twist is that our first mortgage is due to adjust in about 16 months (20 months when we started). Our rate right now is sooooo low (4.125%). So we are aggressively saving – our “401K contribution” + 30% of all takehome pay (after taxes) – in order to be able to accumulate a 6 month emergency fund and refinance before our rate jumps (it would be 9.125% if adjusted today). Once we have our 6 month emergency fund we will start contributing to our 401K again but continue to save 30% of our income and pay off the car loan.
If you said to me a year ago that we could live on 70% of our income I would have said no way! We spent every dime. How do we do it? We just do. If we have $150 for groceries for the week that’s what we spend. We always save first (even if it’s $40), pay our bills and live on the rest. It’s very cool seeing our savings climb. We have an ING account and I love seeing the interest add up too!
Good luck. I hope this helps someone.
TR –
“All debt is evil” is a pretty middle-ages approach to personal finance. Debt is a tool, like a circular saw. Yes, you can slice your hand off with it, but it’s not inherantly evil. The big issue is whether you’re borrowing money to purchase an asset whose value will appreciate, like a house or an education, or an asset whose value will depreciate, like penny stocks or a laptop computer. The first is wise use of debt, the second foolish.