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

LAST REVIEWED Dec 16 2022 10 MIN READ

By Eric Phillips, CFA

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Key Takeaways

  • Debt may affect your ability to contribute to your retirement savings

  • Many times, the interest rate you’re paying on debt is higher than the return you might expect on your retirement saving

  • While there’s no easy solution to this question, it’s may be wise to ask yourself a few questions about your personal situation

Pay off debt first? Or contribute to a 401(k)? This 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.

In this article, we’ll lay out some information to help you understand what’s involved in making this decision. We’ll look at your mind and your money. And 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. According to the SSA, the average monthly Social Security benefit was $1,550.48 in October 2022. Very few people can live on Social Security alone, so it’s often on the individual to shore up their finances for retirement.

If you have debt—be it credit card debt, student loan debt, or another type—those payments affect your ability to contribute to your retirement savings. Many times, 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 assume a 7% rate* of return on your investments and the interest rates on your debt payments are higher than 7%, you could end up losing money if you chose to invest instead of tackle debt. Also, keep in mind the short-term and long-term tax advantages of a 401(k).

To illustrate, let’s assume that 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. Remember, unlike the tangible benefits that can come from paying down your debt, investment returns are not guaranteed and the money you invest is always subject to risk, including loss. 

Life choices: Debt vs. 401(k)

The reality is that many folks with outstanding debt don’t have the funds to completely pay off 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. But on the expense side, you must pay your rent, food, insurance, transportation, and debt payments. The remainder of your spending is discretionary.

How you allocate your money now can influence your entire financial life. Your habits, when practiced over time, can 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 are looking to improve your long-term financial health, then you may 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 you can have a better chance to live 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.

Let’s say you have a choice to put an extra $100 this month towards debt or spend that money eating out. 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 (you can use online calculators, for example this one)¹ 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.

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. Sometimes, the answer to this question depends on personal preference. Some people feel comfortable borrowing large sums of money for mortgages and businesses—and may feel more inclined to contribute to a 401(k) while also gradually paying off debt. Others may prefer to pay off any and all debt as quickly as possible.

If you have low-interest rate loans and expect higher returns on the investments in your 401(k), it may be a good strategy to contribute to your 401(k) while chipping away at your debt—making sure to prioritize high-interest rate debt. But if your debt carries high-interest rates, it may make sense to pay it off aggressively. After you’re debt free, you can ramp up the 401(k) contributions.

If your employer matches your contribution into the 401(k), regardless of your debt levels, you should generally be trying to contribute enough money to receive your employer match. If you don’t contribute, then you’re missing out on free money. When comparing your own debt interest rates with expected returns on investments, evaluate your personal financial situation and look at your investment choices within your 401(k) and carefully review their objectives, expenses, and risk exposures. It’s important to note that investing comes with risk, including the risk of loss.

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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 lower-interest rate debt. Vehicle loan debt may also fall into this category. Yet, when it comes to consumer debt or student loan debt, these you may be required to make lifestyle changes to pay these 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.

Eric Phillips, CFA, has dedicated his career to improving financial wellness. He began his career at Artisan Partners, a global asset management, firm and currently serves as the Senior Director of Financial Partnerships at Human Interest where he works with financial advisors and industry partners to help them offer affordable retirement plans.

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