Should I Pay Off Debt or Contribute More to My 401(k)?
The question of whether to pay off debt or contribute more to a 401(k) is an important one — and one with no definitive answer. After all, no two investors are created equal.
There are also numerous factors to consider when answering the question, such as how on track you are to meet your retirement goals, the amount of debt you carry, and years until retirement.
If you’re wondering if you should pay off debt or contribute more to a 401(k), keep reading to understand the pros and cons, and ideas on how to do both at the same time.
The Real Cost of Debt
That Americans are drowning in debt is an understatement. Debt can be debilitating and can prevent you from reaching your retirement savings goals.
And, if you aren’t careful, debt can follow you into retirement and impact the type of retirement you have.
Let’s take a look at a few recent stats:
Student Loan Debt
According to the Federal Reserve, in the third quarter of 2020, Americans owed more than $1.7 trillion in student loans. This is an increase of almost 4% over the third quarter in 2019.
The average student loan debt in 2020 topped $37,500.¹
Auto Loan Debt
According to Lending Tree’s Quarterly Report on Household Debt and Credit from the Federal Reserve Bank of New York, Americans now owe more than $1.2 trillion in auto loan debt — nearly double what it was just 10 years ago.
The average monthly car payment is $550 for new vehicles, $393 for used, and $452 for leased.²
Credit Card Debt
According to the Federal Reserve, American’s total revolving debt balance is $979.6 billion. While the revolving debt did fall in 2020, it’s still historically high. In July 1995, the number was $409 billion.³
Experian recently reported the average credit card balance in the United States is now $5,315.⁴
No matter what type of debt you have, the payments are taking money away from what you could be saving for retirement.
And, for many debt holders, the interest rate on the debt may be higher than the return you could expect on your retirement investments.
Let’s say you have $10,000 in credit card debt and you pay 13.98% APR. Let’s also say you have a 401(k) with an expected annual rate of return of 7%.
If you decide to only pay the minimum on your credit card and divert what you can into your 401(k), you would be losing money over time on the amount you invested — 6.98% to be exact.
If you are closer to retirement and you have a ton of debt, you need to consider whether or not your retirement income — social security plus distributions from your 401(k) — will be enough to even cover your monthly debts.
The Real Cost of Not Contributing More to Your 401(k)
On the flipside, if you focus solely on paying down debt for the next 5 years, you run the risk of being debt-free 5 years from now, but being behind on retirement savings by 5 full years.
You will have potentially missed out on 5 years of compounded investment returns had you consistently contributed.
And, if you have a 401(k), and you aren’t contributing at least the company match while paying off debt, you may have missed out on 5 years of free money.
After 5 years, you might be debt-free, but you need to play catch-up all over again…only this time with your retirement savings.
On the other hand, it doesn’t make sense to rack up interest and only pay monthly minimums while you contribute to your 401(k) or other retirement funds.
Rethinking the Question: Should I Pay Off Debt or Contribute More to a 401(k)?
Instead of asking whether you should pay off debt or contribute more to a 401(k), we encourage you to ask: How do I pay off debt AND save for retirement?
Asking the question in a new way opens up the possibility you can do both.
It takes a strategy and commitment to following through, but it is possible to pay off debt and save more retirement at the same time.
Here are a few suggestions on how to make this happen:
- Pay off high-interest debt first, while saving something for retirement. At least contribute enough to your 401(k) to get your match because that’s FREE money. If you have an IRA, automate your savings and have money directly deposited when you get paid each month. This way you’re paying yourself first.
- Once you’ve paid off your high-interest debt, continue paying a bit over the minimum on any lower-rate credit cards or debt you have. Then, divert more money to fund an emergency savings account. If you want to avoid getting back into debt, you need access to cash.
- When you have a good chunk of change in your emergency savings, increase your retirement savings. Increasing your contribution percentage just 2% each pay period may make a big difference in the amount of income you have at retirement. Continue paying down debt you have — on time.
- Once your debt is manageable or gone, try and max out your yearly 401(k) and IRA contributions. Keep saving money in your rainy day fund as well. Whatever you do, make sure you don’t go back into debt.
How to Boost Your Retirement Savings without Using Take-Home Pay
If you haven’t received your $600 stimulus yet, or if you have and you haven’t spent it yet, consider putting that money toward boosting your retirement savings.
There are talks of more stimulus money coming, so if you spent the $600 already, you may have another chance to invest a chunk of change in your retirement future.
If you get a tax refund this year — no matter how big or small of a refund you receive — invest it into your 401(k) or IRA.
Using stimulus money or your tax refund to boost retirement savings means you don’t have to reduce your take-home pay or cut back on monthly expenses.
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Sources:
- https://fred.stlouisfed.org/series/SLOAS
- https://www.lendingtree.com/auto/debt-statistics/
- https://www.federalreserve.gov/releases/g19/current/
- https://www.experian.com/blogs/ask-experian/state-of-credit-cards/
