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Debt reduction vs. 401k contribution
Old 04-23-2004, 07:42 AM   #1
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Debt reduction vs. 401k contribution

So I srewed up and now we have two credit cards with high interest rates totaling $13000.

I contribute the IRS max of $13000 (coincidence?)approx. 10% of my pay to my 401k with a company match of 5%, $6500 ,per year.
I am 80% in S&P 500 index and 20% in Wilshire 4500 index. My balance is $256,000.

I want to retire in 17 years.

I ran some calculations on earnings of my 401k balance vs. earnings of my future contributions and feel comfortable that if I suspend contributing until my debt is paid off I will not get hurt too much

Option 1 - reduce contributions to 5% of pay to get full 5% company match, and use other 5% $6500 to pay down debt. Two years here if I roll over to 0% apr cards.

Option 2 - stop contributions and use the $13000 to pay off debt in one year and then resume 401k.

Can you guys give me the pros and cons of each?
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Re: Debt reduction vs. 401k contribution
Old 04-23-2004, 08:02 AM   #2
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Re: Debt reduction vs. 401k contribution

Option 3

Ignore the numbers and stay maxed in all tax deferred options.

I/we lost it more than once credit card/car payment wise in the accumulation phase and engaged in brief periods of aggresively frugal to get things more in line - but stayed maxed in 401k/IRA's.
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Re: Debt reduction vs. 401k contribution
Old 04-23-2004, 08:09 AM   #3
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Re: Debt reduction vs. 401k contribution

Quote:
Option 1 - reduce contributions to 5% of pay to get full 5% company match, and use other 5% $6500 to pay down debt. Two years here if I roll over to 0% apr cards.

Option 2 - stop contributions and use the $13000 to pay off debt in one year and then resume 401k.

Can you guys give me the pros and cons of each?
Well, you won't really have $13K or $6.5K, because that money will now be taxed.

How much can you pay on the credit cards if you don't change your 401k savings?
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Re: Debt reduction vs. 401k contribution
Old 04-23-2004, 09:03 AM   #4
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Re: Debt reduction vs. 401k contribution

EDIT: I was apparently confused when first writing this post; I had four options, the 4th being to max my 401(k) while paying down debt, and at times in this post I seem to think that's what one of zbwmy's options was. Sorry if I'm confusing.

After my job situation stabilized I was in a similar situation 2 1/2 years ago and chose option 1. I had between $19k and $20k of credit card debt plus about $8k-$9k owing on a truck loan.

I came up with 3 options: my third was to find the sweet spot where I minimized both my total burden from taxes and credit card interest. Contributing to 401(k) reduces tax burden while increasing interest costs, paying down credit increases tax burden while decreasing interest costs, and I found an efficient point between max 401(k) and just enough to get company match. As of this post, I have 55 days left to pay off the credit balance; if I had gone with the efficient method it would've been about another year.

Like I said, I chose your option 1 even though I had figured it would cost me more in interest than other options plus have an opportunity cost. I did it because it's a monthly liability, and after the ego bruising I took in my career I didn't want that liability, so it was important to me to get the debt gone ASAP. I'm glad I did, because my job situation became unstable again a few months ago and it was very psychologically helpful to have only a few thousand left on the credit card rather than $10k+.

However, if you're more confident in your income stream(s) than I and aren't as psychologically jittery as I have been then you can find your efficient payoff rate to minimize taxes & interest. Or you may consider the opportunity cost of not investing in the 401(k). As with house payoffs, I doubt there is one correct answer here.

Naturally go frugal during this time, too. I sold the truck (which was worth more than was owing on it), got a cheaper car and found a relative willing to let me put my debt on his card to get a fixed lower interest rate. All that definitely helped.

P.S. Of course it's not simply a psychological issue. If I were to have lost my job and needed to tap my 401(k) it would have cost me taxes plus penalties plus opportunity cost. I didn't mean to make it sound like my decision was purely psychologically based.

P.P.S. If anything comes close to or surpasses the "certain returns" of paying down debt, it's getting a 401(k) company match, especially if you're already vested, which I was. If you're vested and you have enough in your budget to consider maxing the 401(k) I can't imagine a situation where you wouldn't want to get the company match. If you're not vested yet then it's a little fuzzier but still nearly a no-brainer.

P.P.P.S. My job situation is stable again now; in fact I have a couple of unsolicited potential opportunities in the very near future.

P.P.P.P.S (I'm big on afterthoughts today.) I wasn't very clear about my efficient mix; it's like this: as you pay more toward 401(k) there is a point where the tax saved ls less than the interest charged on the CC. At that break even point I would pay less total taxes & interest on the affected monies over the payoff period than any other payoff/savings rate over their payoff periods. So assuming a reliable income stream and ignoring opportunity cost you keep more of your money at that efficient payoff rate.
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Re: Debt reduction vs. 401k contribution
Old 04-23-2004, 09:54 AM   #5
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Re: Debt reduction vs. 401k contribution

I can't pay enough each month towards the cc debt to be done in two years. Money is tight right now. I realize I will be taxed at about 28% on any amount I do not contribute to the 401k.
I guess I am also looking for a mental edge to getting this accomplished. Maybe I should do option 1?
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Re: Debt reduction vs. 401k contribution
Old 04-23-2004, 11:35 AM   #6
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Re: Debt reduction vs. 401k contribution

I'm with unclemick. Aggressive frugality is the best option here - if it is possible. Otherwise I'd choose your option 1. Getting that employer match is a guaranteed 100% return on your money in the first year. I wouldn't give that up, even for only one year.
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Re: Debt reduction vs. 401k contribution
Old 04-23-2004, 01:16 PM   #7
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Re: Debt reduction vs. 401k contribution

I wouldnt cut back on the pretax investment options.

Frugalize...but I realize that sometimes you're at the bare bones. If you arent packing your lunch to work, giving up the vacations and dinners out, and arent deferring any other completely non-essential lifestyle elements, you aint frugalized yet.

If you cant frugalize the money out of your lifestyle, consider a second job unconflicting with your first.

When I wanted to dig myself out of some credit card debt (in my 20's), I took a second job working in a hardware store roughly four hours per evening, four days a week, and I worked the midnight to 8am saturday and sunday night shifts at a convenience store for double the usual hourly rate.

The midnight-man shifts sucked. But they paid handsomely. I actually liked working in the hardware store...it was a nice contrast with the hardware and software design job I had during the day.

After a year of doing this, I was pretty tired. And out of debt. Never carried a credit card balance from one month to the next since.

You might also consider a home equity line of credit, move the credit card balance to that while you pay it off. At least the interest may be tax deductible.
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Re: Debt reduction vs. 401k contribution
Old 04-26-2004, 11:49 AM   #8
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Re: Debt reduction vs. 401k contribution

If those are your only two choices then option 1 wins by a mile. Especially if you can get enough 0% cards that you don't have to pay interest.

If you want a mental edge you may want to check out Dave Ramsey's Financial Peace, or one of his other books. He's a good motivator for getting out of debt. I'd especially recommend the audio tapes (from your local library, of course). It helps to listen to his goofy stories out loud.

I'd strongly encourage you to look for other ways to pay off your debt besides cutting into your 401k payments. Your tax sheltered investment opportunities are calendar year -- once they're gone you can't make up for it a year later -- and they have tremendous lifetime value. I know it may seem impossible now, but if you really get into the frugal mentality it won't be hard at all to come up with the $6500 to fund the rest of your 401k, and $3000 to fund a Roth, and pay down that debt all at the same time.
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Re: Debt reduction vs. 401k contribution
Old 04-26-2004, 12:43 PM   #9
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Re: Debt reduction vs. 401k contribution

Quote:
... Especially if you can get enough 0% cards that you don't have to pay interest.

....
I'd strongly encourage you to look for other ways to pay off your debt besides cutting into your 401k payments. Your tax sheltered investment opportunities are calendar year -- once they're gone you can't make up for it a year later -- and they have tremendous lifetime value. I know it may seem impossible now, but if you really get into the frugal mentality it won't be hard at all to come up with the $6500 to fund the rest of your 401k, and $3000 to fund a Roth, and pay down that debt all at the same time.
I would agree with the opinion to maintain your 401k contribution, at almost any cost. Treat is as if it is not part of your paycheck, not as optional savings. Your pay should be considered to be what you take home after 401k, taxes, etc., not your salary! It's just a mindset thing, but I found it useful in my savings years.

Also, credit card rates are expensive. There are usually ways to reduce the costs. I seem to get offers every week (or day?) to transfer balances at 0% or other very low rates. I would caution you not to let that distract you from your goal of getting them paid off, but if there are ways to reduce the interest expense, then by all means do it. And then read the fine print - you often do NOT want to use the card you are getting 0% interest on the transferred balance from. This is because payments are applied first to the 0% balance and then to new purchases, and the interest creeps back up if you add purchases in.

Good luck!
Wayne
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Re: Debt reduction vs. 401k contribution
Old 04-26-2004, 02:52 PM   #10
 
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Re: Debt reduction vs. 401k contribution

I have made thousands
of dollars by taking CC promo interest rate offers
and finding a short term home for the cash elsewhere,
thereby pocketing the rate spread. You have to do the
math and watch the fees, term of promo rate, etc.
It also helps to have very large credit limits. Once I draw
down the whole credit line, I never use that card again until the balance is paid off, for the reason mentioned
in the prior post. It's the closest thing I've found to free money.

John Galt
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