Should I contribute to my 401(k) or pay off debt?


By Barbara A. Friedberg

Whether to pay off debt first or contribute to a 401(k) is an important question to evaluate for those with debt, but still worried about saving for retirement. There are many considerations when pondering this question, such as how much money to direct towards your debt and how much towards retirement, and when!

First, we’ll lay out some information to help you understand what’s involved in making this decision. Next, we’ll take a unique approach to this complicated question and look at your mind and your money. Finally, we’ll investigate how to decide whether to contribute to your 401(k), pay off debt, or do both.

Debt and retirement facts

Let’s look at the facts. The average Social Security payment in 2016 is $1,341 which equals $16,023 per year. Very few individuals can live on Social Security alone, so it’s on you to shore up your finances for retirement.

If you have debt, whether it’s credit card debt, student loan debt or other, those payments are taking money away from your retirement savings. Additionally, in most cases the interest rate you’re paying on the debt is higher than the return you might expect on your retirement savings. For example, if you invest in a diversified stock index fund, with a projected 7% rate of return but if the interest rates on your debt payments are higher than 7%, you would be losing money if you chose to invest instead of pay off debt. Also, keep in mind the short-term and long-term tax advantages of a 401(k).

Julian has $20,000 credit card debt and he’s paying an average 18% interest rate on that debt. So, even if he invests and receives a return of 7% on average for his investment dollars, he’s losing 11% (18-7=11) on the money he’s choosing to divert towards investing in lieu of paying off the debt.

Life choices: Debt vs. 401(k)

Now that we’ve examined a scenario, the reality is that most folks with outstanding debt don’t have the funds to completely payoff the debt immediately. You may even have a negative net worth. Here’s where your mind comes in.

Before you move forward in your financial life, you need to make some important decisions. You have limited financial income and vast financial wants and needs. On the income side, you need a job and on the expense side, you must pay your rent, food, insurance, transportation and debt payments. The remainder of your spending is disposable.

How you allocate your money now can influence your entire financial life. Your habits, when practiced over time, become permanent. If you continually finance your “wants” with credit, that behavior can become permanent and lead to a lean financial future. Now is the time to ask yourself the hard questions:

  • Do you want to struggle financially during your adult life?

  • Are you seeking a life free from long term financial stress?

If you don’t want to struggle and are looking for long term financial comfort, then you have to spend less today to free up cash for debt repayment. That means, you need to learn to cherish living with less and delaying gratification now, so that you’ll have a life without long term financial stress. This is where the hard decisions come, and you’ll need to learn to say “no” to yourself. Train yourself now, to live on less, and it’ll be easier to pay off your debt and contribute to retirement.

Envision that you have a choice to put an extra $100 this month towards debt or spend that money eating out. Let’s see what happens if you choose to eat out. If you pay a $4 minimum on the $100 debt, then it’ll take you 32 months to pay off the debt (use this hand debt repayment calculator) and in the end you’ll have paid a total of $128 for a $100 purchase. By continuing to make only minimum payments on the debt, you’re paying a great premium for everything you buy on credit.

What the pros say: Should I contribute to my 401(k) or pay off debt?

There’s no easy solution to whether you should contribute to your 401(k) or pay off debt. Here’s what several financial advisors recommend to their clients.

Grant Bledsoe, CFA, CFP, Portland financial planner and the founder of Three Oaks Capital Management reminds us that each of us has a different comfort level with debt. Some people are okay borrowing great sums for a home, business, auto and other large purchases. Whereas others can’t sleep at night with the smallest amount of debt. If you’re one of those individuals that abhors debt, feels terrible with the debt hanging over your head, then pay it off as quickly as possible.

On the other hand, Joseph A. Carbone, Jr., CFP®, Founder and Wealth Advisor at Focus Planning Group Group doesn’t differentiate between those that can tolerate higher debt levels and those that can’t. Carbone recommends paying down debt first for all. He suggests paying off the highest interest rate debts first and continue until all of the debt is paid off. Carbone’s rationale is that in most cases, as we previously discussed, the interest rates on the debt is higher than that of the expected returns on your investments. Thus, carrying debt and paying into your 401(k) equates to a net loss.

There’s one more factor to consider. If your employer matches your contribution into the 401(k), then regardless of your debt levels, you need to contribute enough money into the 401(k) to receive the employer match. If you don’t contribute, then you’re throwing away free money.

If you’re still on the fence about whether to pay off debt, fund your 401(k) or both, Bledsoe drills down into the issue further by projecting future potential returns on investing. Grant fleshes out the numbers by suggesting, “We can expect returns of around 8.5% (a bit higher than our prior conservative estimate) in the stock market over the long run, and somewhere between 2%-4% for bonds.”

If you have low interest rate loans, and expect higher returns on the investments in your 401(k), it’s a good strategy to contribute to the 401(k) while you are also paying off the debt, making certain to pay off high interest rate debt first. When comparing your own debt interest rates with expected returns on investments, take a look at your own investment choices within your 401(k) and their projected future returns.

If all of your debt carries high interest rates, then pay it off aggressively first and only contribute the minimum required to your 401(k) to secure the employer match. After you’re debt free, you can ramp up the 401(k) contributions.

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The takeaway

There’s no perfect answer to this question that applies to all. In general, mortgage debt will be with you for a long time and is generally very low interest rate debt. Vehicle loan debt may also fall into this category. Yet, when it comes to consumer debt or student loan debt, you will thank yourself if you make the required lifestyle changes to get these financial obligations paid off aggressively. It’s difficult to meet other goals such as saving for retirement and buying a home while you are saddled with excess debt.

Image credit: Roman Drits

Veteran portfolio manager, expert investor, and former university finance instructor. She has authored 3 money/investing books. Friedberg also owns the financial websites and

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