401(k) Contributions With Outstanding Debt

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Stop 401(k) contributions to speed debt reduction?

DFA Reader James P. asked:

Should I stop 401(k) contributions of $546 a month to pay off the car loan faster??? This will bring my monthly excess for debt payments to $1100. I use the 50/50 plan (50% of excess income goes to pay down debt, 50% is saved).

Matt, I would like to say your blog is one of the first websites I check in the morning for inspiration and knowledge. My family of six embarked on the Dave Ramsey journey in June 2008. Since then, we’ve paid off $47,000. $34k of that was credit card debt (ALL GONE!!!!) My wife and I are 34 and our sons are 14, 13, 10, and 10 so we are very proud of ourselves and the amount we’ve paid off considering the responsibilities we have.

I am currently putting 7% in my 401(k) (receiving a 2.5% match). My wife is currently putting 4% (receiving a 1% match). Our remaining debts include a mortgage, a car loan ($32,000 @ 6.9%) on an ‘08 Toyota Sienna (worth $26,000) and two student loans (totaling $23,000 @ 6%). The Dave Ramsey plan would pay the smallest debt (a student loan) first, but I’m conflicted as to what to do next. My thought is pay off the car next because it is my biggest payment, but I would have to stop my (not my wife’s) 401(k) contributions to make it happen in 1 year. My fear is, if I stop the 401(k) contributions I will miss out on a significant rise in 2010. I will keep the student loans for now because they are tax deductible. Getting the car payment off me would lift an emotional burden but my 401(k) contributions are making me have second thoughts.

Congratulations!

Anyone who has paid off nearly $50,000 in debt in two years deserves a pat on the back. You have been doing a great job, let’s have a look at your situation and see if we can help speed you toward debt free living.

Your Plan or Dave’s Plan?

You want to pay off your car because it carries a higher interest loan, but Dave says you should pay off a student loan, because it is smaller and he wants you to have fewer debts regardless of the numbers. Well, I agree with you. Dave’s debt snowball makes sense for people who lack motivation, have a multitude of smaller debts (3 credit cards, 4 store charge cards, and a couple major appliances) and can benefit from the visible progress of paying off individual debts. However, the amount you paid off this past year shows you are VERY motivated, and down to three big debts. The other reason I agree with you, is that the student loans are unsecured, your education cannot be repossessed, and while the tax deduction isn’t a great reason for keeping the loan around, when combined with the lower interest rate, it isn’t costing anywhere near as much as the car loan. You already owe more on the van than it’s worth, which is not a desirable situation.

A Better Rate of Return

Having established that your plan to pay off your vehicle before the student loans is sound, we will now look at how to do it. A 1-year timetable is a good goal; dragging debts out is never good and the amount is only slightly higher that what you paid off the last two years. You tell us the money you need to pay off your car in one year is currently being contributed to your 401(k). The way to do it then is obvious, your 401(k) contributions must be adjusted, and I am going to address how and why.

You are currently contributing 7% of your salary, and 4% of your wife’s into 401(k)’s although you are only being matched for 3.5% of those contributions. That means you have 7.5% of your salaries that I would consider “extra” contributions. I always recommend that people in debt (including a mortgage) not contribute any more to a retirement plan than is matched by an employer. When contributions are matched, you get a 100% return on investment with zero risk. There is no better investment than that, but for unmatched contributions to net a profit, they must produce returns in excess of what you pay in debt interest. On average, the stock market returns 8% over 30 years. While that is higher than the interest you pay on your debts, ask your self if a volatile investment with a 20-30 year timetable is worth 1%-2%. Paying off your debts offers an immediate guaranteed return of 6%-7% in your case. That is a much better deal.

Planning For an Uncertain Future

You mention your concern that next year may be a good year for the market, and you want to get in on it. Since none of us can know the future and because different “experts” are all just guessing anyway… I would counsel that your investment decisions should be based on where you are financially, not what the markets are doing. Get out of debt, save money, avoid future debt, then invest your surplus.

I would recommend reducing your and your wife’s 401(k) contributions to the amount that will be matched. You will then have the necessary money to pay off your car, then shift your attention to the student loans. Once they are gone, bring your emergency fund up to at least $10,000 if you have not already, and then turn the hoses on the mortgage. Once you are completely debt free, you will have the excess income necessary to max out your 401(k) contributions (as well as a Roth IRA if you are eligible) and your retirement savings can grow steadily without interference from debt.

Do You Have Any Other Advice for James?

Something you think I missed? Drop a line in the comments below.

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1 Jolyn@Budgets are the New Black

We recently paid off almost $20k of debt in about 10 months. To do this, we did stop all retirement contributions. My husband is military, so there is no match, and I am a SAHM.

As soon as we paid off the consumer debt I started putting all the excess in savings, and even though January 1 had come and gone I took that savings and squeezed $5k out to make a ROTH contribution before April for the prior year, which was the max amount for an individual for 2009. That helped lessen the blow of missing out on my husband’s retirement contributions during those 10 months.

I do not regret what we did one iota. We are already well on our way to maxing out my ROTH for 2010, and will be starting one for my husband as well. We, too, were inspired by Dave Ramsey to eradicate our debt and live without using credit.

If I were this family, after their employers’ matches I would make ROTH contributions a priority, assuming they are eligible. They’re doing an amazing job and are already changing the legacy for their children!

2 Paul

I agree that extra car payments should take priority over extra student loan payments for you. But I hesitate to reduce your 401K if it means losing the employer’s contributions (free money). If you can reduce your 401K without losing a dime of what your employer contributes, then do it. If not, then don’t.

3 Nicole

Read carefully. They were putting in *MORE* than what their companies would match. Example: one was putting in 7% of their salary, but their company would only match 2.5% of that amount. The advice here is to take that 7% and put it down to just 2.5%. They put in 2.5%, the company puts in 2.5%.

4 Matt Jabs

Yep.

5 Matthew

@Nicole Not so fast…usually employer matching plans are a percentage of what you invest up to a certain percentage of your base pay. For example, my employer matches 25% of what I put in up to 6% of my base pay. So, if i put in 4%, my employer matches 25% of that (1%), bringing my total 401(k) contribution to 5%. However, I don’t get the tax break on the match. I would strongly advise on reviewing your company’s matching policy, as I would highly doubt they will match 100% with minimal investment.

In my case, in order to get my company’s full 6% match, I have to invest 24% of my gross pay in my 401(k), which I do; this gives me a full 30% of my gross pay in my retirement account, of which I only contributed 24% (the 6% match is FREE money). I cannot simply lower my contributions to 6% and keep my 6% match, as that would result in only a 1.5% company match (25% of 6%=1.5%), yielding a 7.5% 401(k) contribution.

@ Blogger Lastly, you note 8% over 30 year on the stock market. That is the AVERAGE return per year if invested over 30 years. You’re leaving out that a 401(k) reinvests your interest earned, compounding the interest. $100/yr invested over 30 years compounded ONLY once/yr @ 8% (usually it will be per month in a 401(k)) yields $12,234 ($100 x 30yrs=$3,000 invested; the difference is your investment profit). This results in a lifetime interest yield of over 400%. (This is why every financial advisor will tell you the earlier you invest, the more money you will earn due to compounding.)

Your car payments do not carry compounded interest, as you are amortizing the principal and interest. Your total interest over 3 years is $4,000; over 6 years is $8,000. So, by reducing your 401(k) contribution to pay off your car (or any loan for that matter) is not financially responsible. You need to “pay yourself first”, i.e. 401(k), and then pay off debts to creditors. If you do otherwise, you’ll still have a retirements nest egg, but it will likely look like a robin’s instead of an ostrich’s.

6 David H.

I wouldn’t recommend putting any money to that car and instead head right to the bank and start negotiating. It seems to me they bought the Sienna new back in 08. I’d recommend selling the car and take out a loan for the difference which will drastically reduce your debt. Buy a $2,000 junker and name it BIG RED. Your kids are old enough that you don’t need the ultra reliable new car.

7 Jenna

I’m debating seconding this idea. You’re child is a year away (in most states) from getting a learner’s permit for driving. Chances are you don’t want to have a brand new car for him to drive (a safe one definitely) but not a brand new one. To add to this you have to take into account higher insurance rates for cars for a new driver. Might be worth it to get a junker.

I would only contribute what your employer will match to your 401(k) plan as well.

8 Budgeting in the Fun Stuff

I agree in general but have slightly different priorities:

1. 3 month emergency fund
2. Minimum to get maximum company match in 401k.
3. High interest debt (greater than 10%)
4. At least one Roth IRA if you and your wife are eligible
5. Lower interest debt (car loans, mortgages, student debt, etc.)
6. Raise the emergency fund to 6 months or a year and max out second Roth IRA.

We are currently at step 5…we’re paying off our remaining car loan ($9500 for my husband’s used Prius at 4.6%) before tackling our mortgage even more than we have since the beginning (we have about $70,000 left at 5.375% on a 15 year loan that is on schedule to be paid off in 10 years or less total).

It’s all about priorities. Our biggest financial goal is retirement by age 52, so obviously we placed Roth IRA’s higher than some people would.

What would you like more, to retire earlier but waste more money on debt or to pay off your debt and catch up in a couple of years on retirement? Valid question that only you can answer…

9 Jason @ One Money Design

I also like reducing the 401(K) investment down to what is required to get the match. Make sure you have at least $1000 in savings before paying more on your debt. You might consider $2000 or one month’s living expenses if there is any hint of unemployment or major expenses coming your way for the kids or something else.

Regarding the car, that’s a hefty debt. Have you considered what you could get for it if you sold it yourself (maybe that’s the amt. you mentioned)? Maybe you could sell it yourself and get closer to the pay off amount? It would be nice if you could somehow reduce that large debt and still have a good used car that meets your needs. You might have to come up with some extra money to make up the difference (perhaps your reduction in the 401(K). I’d rather see you tackle a much smaller car debt and then get after the student loans.

10 WR @ Worthwild.net

Very interesting read here.

Before you drop your 401(k) contributions, take a look at your taxes. There are many scenarios where pre-tax 401(k) contributions will result in fractional differences in your take home pay and even some cases where contributing will raise your take home pay. This depends on your tax rate.
plug your own numbers in to Bankrate’s 401(k) calculator and see what you come up with:
http://www.bankrate.com/calculators/retirement/401-k-contribution-calculator.aspx

Remember to only count your money after it has passed through the filter of taxes.

Perhaps instead of reducing your 401(k), you could investigate other ways to reduce your tax burden.

Have you considered starting a home based business? Start up costs, equipment, Home office, Mileage used for business purposes, etc are all deductions. In fact, first year business expenses can significantly reduce your taxes making it even easier to pay off your debts.

-WR

11 Robert Espe

Contrary to popular opinion, it is not possible to increase your cash flow through tax deductions. Why? Because you cannot deduct more than you would have paid in the first place, and.in order to claim a deduction, you must spend the money, so whether the money goes to Uncle Sam, or Office Max, it is no longer in your pocket where it can be used to pay off debt.

While contributions to a 401k are pre-tax contributions, and you won’t get to take home all of your former contributions, unless you are in the (non-existent) 100% tax bracket, there is no way that reducing your contributions would not increase your take-home pay. It is possible that most of the difference might be WITHHELD from your bi-weekly check, but most of it will come back to you when you file your tax return at the end of the year (all of which should be applied towards debt).

12 WR @ Worthwild.net

I am sure you are convinced of your disagreement but let me try to persuade you otherwise.

Expenses you incur for your business ( Business lunches, Computer equipment (yes, even that Ipad you’ve been looking at), research into the viability of an enterprise, travel related to your business) are deductible. These are things most of us buy and/or do whether we are in business or not. The trick is to think like an entrepreneur and start a business that is in line with your passion and purpose.

Your home office deduction comes out of the property you already own. Mileage deductions come from the car you already drive. Office equipment deduction comes from…you get the point.

Businesses are taxed only on profits, employees are taxed on wages. Once you understand the difference, the light-bulb will go on and a whole new world will open up to you.

-WR

13 Robert Espe

Unfortunately, this only legitimately applies to pure business expenses, meaning that whatever you desire to deduct must be used EXCLUSIVELY for business purposes. For example, yes you can deduct the value of a home office space or computer, but only if it is exclusive office space (if the kids ever play in there, you can’t claim the deduction, same goes for if they ever get on the computer). While this is common practice, and many people get away with it due to the limited manpower of the IRS, it is still not a viable legal option. If you don’t believe me, call the IRS and ask them (my uncle is a revenue agent).

The advantage to deductions is they keep us from paying taxes on money we don’t receive as spendable income(mortgage and student loan interest, health care premiums etc.). For example, this past year I was able to deduct moving expenses, I spent and then deducted $3,000 from my taxable income. I didn’t have to pay taxes on that $3,000, which was good because I was moving either way. But had I not moved, I would have had to pay taxes on $3,000, but that would have left me with more than $2,000 in my pocket. The deduction saved me money because I moved, but moving didn’t make me any money. Better the money not spent with taxes paid, than spent and deducted.

14 Paul

I hate to admit this, but I forgot the tax implications when I made my original comment in this thread. Oops!

Suppose you have $100 and you are deciding whether to invest it in your 401K or use it to reduce your car debt. By applying it to your car loan, you are increasing your net worth by $6.90 in one year. But by applying it to your 401K, you gain not only the 401K stock market advances (or declines) … say an average of $6 to $10 a year, but you also gain ~ $30 to $35 (depending on your federal tax bracket and state tax situation) by avoiding $100 of reportable income, not to mention the “free” dollars offered by your employer in terms of 401K matching. I am afraid it makes more sense to keep charging hard on the 401K from a math perspective, although emotionally it may feel better to knock out the car loan quicker.

15 skrpune

I found a great “invest or pay down” calculator here: http://www.planningtips.com/cgi-bin/prepay_v_invest.pl.
It’s geared towards mortgages, but you can use it to calculate interest paid for other loans/debts and it will help you figure out if you can save more by paying down debt or earn more by investing. Not iron clad, but a great tool.
Also, the Fidelity investment calculator is great too – lets you see how your investments may grow over time: http://personal.fidelity.com/toolbox/growth/growth.shtml

16 Travis

i would say bills… here is a funny joke I saw about outstanding debts, http://ponderingstuff.com/2010/07/05/entering-the-witness-protection-program-to-get-rid-of-bad-debts/

17 WR

I should reiterate that I believe habits need to be formed concurrently.

Contribute to your 401(k) while you pay down your debts. Developing the ‘rituals of wealth’ will pay off for you in a short time-frame.

Give to Charity with a Percentage of your income.
Build your 6 month contingency fund with a percentage of your income
Pay your debts with a percentage of your income.
Fund your 401(k) or IRA as well.

here is a little flowchart I have devised:
http://worthwild.net/blog/?p=165
ymmv

Starting a legitimate business is one of the ‘optional’ keys to financial independence. You can do it without it but I encourage you to look into entrepreneurship as an option.

-WR

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