Retirement plan decisions made easy
Drill Down: Contribute to a 401k or Pay Off Credit Cards?
Here’s the most extreme question about contributing to a 401k or paying off debt. Assume for the sake of argument that you have a credit card that charges a fairly high interest rate. Should you pay off the card first, or contribute to the 401k first?
Let’s describe the happy case where you pay off the credit card first. You put all of your discretionary income to work paying off the credit card tab and avoid adding any more credit card debt. You get out from under the 18 percent (or whatever) interest rate you had been paying on the debt. Now that you are used to living on less money, it’s easy to contribute to your 401k.
Now consider the unhappy case: you don’t contribute to the 401k, and you still rack up credit card debt. This leaves you with high debt and no retirement savings, the worst of all worlds.
So what should you do? First, let’s look at how you incurred the debt. Let’s say that your debt was relatively small, but then you had a major unavoidable expense, like a large medical bill, or the car you use to get to work needed a major repair. You don’t have a behavioral problem—you simply need to dig yourself out of some bad luck. Okay, delay contribution to your 401k, but put yourself on a firm schedule to pay down the credit card debt by a specific date. And keep to that schedule.
Now let’s look at the harder case: you racked up a large credit card debt simply because you spent too much. Not once or twice, but over and over again. Clothes, sporting goods, and vacations have all added up over a period of years to a large credit card bill. You really need to change your behavior. If your behavior is not going to change, at least fund your 401k so that you’ll have a retirement account, even though you are wasting thousands of dollars paying a high interest rate. However, I’d prefer to see you work on the behavior. Here are some steps that frequently help. First, figure out where you are spending money. Use Quicken or another computer program to track expenses.
Second, create a belt-tightening budget. This is a two-step process. The initial step is to create an extremely severe budget, which eliminates all luxuries, frills and recreation. The next step is to add back a little money for the luxuries and recreation that are most valuable to you. For instance, most married couples should get out of the house without the kids every week or two, so you might add enough for a date—a cheap date, though.
Some people find it hard to avoid using credit cards for impulse buying, but they want to keep a credit card handy for emergencies. Here’s the solution: put the credit card in a zip-lock bag filled with water and place the bag in the freezer. You have to thaw the bag to use the card, giving yourself some cool-down time. A simpler version is to keep your emergency credit card in your wallet, but wrapped in paper, taped shut. That may create enough of a bother that it prevents impulse buys.
The hard numbers show that paying off a high interest rate debt before contributing to your 401k makes sense, but only if you follow through by paying off the debt and then getting started with your 401k. If you can’t do that, contribute to the 401k and accept that you’ll be in debt for a longer time.
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Lesson 1: What the Heck is a 401k, and What’s So Great About It?
» Lesson 2: Contributions to Your 401k
Lesson 3: Investments “Cook Book” Approach
Lesson 4: Investments: How Investments Work
Lesson 5: Loans and Hardship Withdrawals from Your 401k
Lesson 9: Your 401k, Your Other Assets, and Your Life
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