401(k) versus debt reduction

Next month I will be eligible to start a 401(k) after being at my job for one year. It sounds like a no-brainer, but I am honestly still mulling it over.

Now before jumping all over me, hear me out. There is something to be said for having a clear mind and not having debt hanging over your head. I still have some college loans and credit card debt to pay off, and I have half a notion to clear that before investing in my future.

Yes, I would forfeit the growth potential of my 401(k) during that time but I also would be paying less interest on my loans if I pay them off quicker.

I sat down with a financial services professional last month to discuss whole life insurance. It is another sound opportunity, but I decided to put it off for the time being and stick with just the standard life insurance I have. The lease on my car is up soon so I would like some money handy and the holidays are not that far off.

Doing some research on my financial future, I stumbled upon an adviser's answer to a similar 401(k) versus paying down debt question. The response to the effect of, "Create a tight budget and do both," sounds good. I am all about responsibility but sorry, I am not about to make tons of financial sacrifices.

If I did not drink beer I probably would be in much better physical shape, but that is not going to happen any time soon either. I have some friends who live that way (fiscally, not alcohol-free) and cannot imagine turning down all the fun experiences they have passed up because they were watching their wallets.

My concern is that if I do not at least start my 401(k), though, I may find myself putting it off in the future as well. If I force myself to do it now, even on a small scale, then at least I will have a start.

Anyone else out there have any experiences or advice to share?

---Geoff Nason

Comments

[Steve-O]

I struggled with this same dilemma and in retrospect I wish I had started the 401k sooner. Its painful to start because your always thinking about what you could be doing with that money, but once you get used to that money being out of your check the rest of your budget adjusts and you stop thinking about. At this point though, I wouldn't put in more money than your company will match.

[Wisconsin Badger]

Geoff,
Might I suggest that you take advantage of one of Western New York's "resources"... gaming facilities! Playing the tables at Seneca Niagara or Fallsview could yield a nice sum of money for your retirement. If you're feeling less risky, the slots would be a good choice (Fort Erie, Hamburg Fair).

[Nick]

There are a lot of advantages to the 401(k), so think carefully before not participating. Remember that the 401(k) is tax deferred and that most plans have a match and let you loan a portion of it. For example, assume you make $30,000 a year, have $3,000 in credit card debt, your plan matches 50% of the first 6% of your salary and lets you take a loan from the plan for 50% of the balance.

If you contribute 6% to the 401(k) ($1800), you'll get a match of $900 and, conservatively, investment appreciation of 5% ($135), so after a year, you have $2,835 in the 401(k). After 2 years, you'll have about $6,000 in the 401(k) and can take a loan from the plan to pay off the credit card (you'll have to pay the plan back, but you're paying yourself and typically at a much lower interest rate than the credit card) - not to mention, you still have $3,000 left in the 401(k) that you didn't borrow from yourself.

If you instead tried to use the $1,800 you would have put into the 401(k) into debt reduction, you really only have about $1,500 (because you missed out on the tax deferral), so you can still pay off the credit card in two years, but you'll have no savings at the end of it.

Regarding student loans, consider paying them off early very carefully. They typically carry a very low rate of interest which is tax deductible - so, while the payments may be high, you really don't have significant carrying costs to keeping the debt and would probably earn more investing then you pay in interest.

There's a lot of assumptions in what I just posted, and it doesn't take into account your mental well being (there is something to be said for being debt-free), but I would recommend that you sit down with someone you trust (maybe a friend from college that was a finance major?) who isn't selling you something and run the numbers. A lot of what you do has tax implications, so be mindful of that as well.

[The Jesus of Cool]

Geoff,

Without knowing how much student debt we are talking about and how much income you have coming in the door, I would say, 'in general' to definitely work on that student debt as nothing will make it go away except paying it off.

Consider:

-bankruptcy will not erase student debt

-yes, you can get forebearances, etc but it only delays payments and adds fees and capitalizes interest so the balance grows.

-401K balances can be taken in cases of divorce, bankrutpcy, civil judgements, etc.

-the bad credit history of defaulting on student debt can impact future employment with credit checks, etc.

-future uncertainty - if you get hurt or lose your job, it will hamper your ability to earn and pay off the student debt.

I know it isn't a hip notion to hold, but I really can't stress enough how bad it is to carry debt.

Yes, the future value of money invested in a 401K is very powerful, but if you can pay off the student debt first, I would do that. Get a second job bar tending or waiting tables on the weekends, even.

[Don H]

Put off building your 401 and "have fun" now, but be prepared to work during normal retirement years.

[Lisa]

At least put the % that your company will match - that is part of your compensation. If your company offered you a raise - would you decline - no - so do not decline on them matching your 401k. I think it is about finding the middle ground - do not put yourself in a position where you cannot afford to do anything fun but do try to cut back a little. If you put off your 401k now - then there will always be an expense coming up or something that will allow you to not contriubute to your 401k. So I say contribute now especially before kids because once you have children your life becomes much more expensive!

[Amanda]

My take on the subject is this - studies prove that many times your 401k brings in a better return than the interest you're paying on debt, especially school loans.

Now, if you've got a credit card sitting at 20% interest, by all means, pay it off asap, but not before calling your credit card company and asking for a lower interest rate.

One thing to understand is that there's "good" debt and "bad" debt. Good debt includes assets that appreciate, like a house, and things that will help your future income, like school loans. Bad debt is any credit card debt, especially.

I would NOT advise you to wait to open up your 401k, because, as you said, you're likely to keep putting it off. Open the account, and as the other commenter advised - just put in enough to get the full company match. The company match is FREE money - don't let that opportunity slip through your fingers!

As far as life insurance, you don't need a whole life plan. If you have no life insurance, buy term insurance. It's cheaper and better insurance. You don't need much life insurance if you're a single guy in your 20's, either. It's not like you're the breadwinner for your entire household or have a baby to provide for. However, if you do get married or have a child, up your life insurance at that point, but go with term rather than whole life.

[The Jesus of Cool]

Geoff,

You are spot on about reducing debt. Paying it down will give you greater freedom in your 30s/40s and beyond.

If you are feeling masochistic, read some of the student loan horror stories at http://www.studentloanjustice.org/

I am in finance/IT and was fortunate enough to pay off my undergrad/grad debt in 5 years. It's a great feeling. I read about people in more liberal arts-type careers who really struggle because the salaries can be a lot lower, although the work is probably a lot more meaningful than my own.

If you are able, I would put the bare minimum in to get the matching dollar amount from your employer into your 401K. If you don't have any dependents (children or spouse) I wouldn't be too concerned about whole life insurance. If I had to guess, you are probably being pitched something.

Instead, if you have axtra money beyond the above, I would put it into your 401K before it is taxed. The allowable max is currently 15,500. If you still have money after that, either look at index mutual funds from a do-it-yourself mutual fund like Vanguard or a down payment on a house if you don't already have one.

Being in sales, I can confidently tell you - Never take advice from people who also sell items related to the advice being offered.