Sorry if we’re going to sound like your parents for a second, but financial planning is a huge piece of setting your future up. Putting away money rather than spending it as soon as you get a paycheck can lead to things like saving for a house, planning a vacation or buying a car, among other things. So it’s important to understand how to get the most out of your money.
Two factors that can play hugely in your financial planning are a 401(k) and some credit card debt. One can help your money grow over time, while the other will help eliminate debt with, potentially, high interest rates.
So, if you have cash to pay down credit card debt or have the opportunity to participate in a workplace 401(k) match, but can’t do both, which should you choose? Here are some factors to consider that can help you decide.
I had a friend who was making a six-figure salary, but who was heading towards bankruptcy due to massive debt. I asked her if she was making 401(k) contributions. She said she was contributing about $500 per month. I asked her if that $500 per month would help her deal with her immediate cash shortfall, and she said yes. She decided to temporarily stop making 401(k) contributions and use that money to reduce her interest-bearing debt. Some months, she needed that $500 just to pay all her bills.
If you’ve got the opportunity to contribute to a 401(k) or pay down debt, you need to consider the pros and cons of each. In many cases, paying down even high-interest debt is a short-term solution to a problem that will cost you much more in lost retirement savings over the long run. Sure, debt is always an inconvenience, but it might be better to keep making 401(k) contributions while you cut back your spending as a way to earmark money for debt reduction.
However, when your debt is suffocating you, it might be better to stop making 401(k) contributions for a time to avoid damaging your credit by missing bill payments, taking on a debt consolidation or ultimately declaring bankruptcy.
There are two obvious and significant benefits to making contributions to a 401(k) account and help your financial planning for the future.
First, if your employer offers a match, you’re getting “free money.” A common match is half of your contribution, up to 3 percent of your salary. With a company that matches half of your contribution, you’ll need to put 6 percent of your paycheck toward your contribution, but you’ll get another 3 percent from your employer.
The second benefit of a 401(k) is that it earns you compound interest, or interest on your interest, each day. Over the course of decades, this makes your nest egg balloon.
With a tax-deferred 401(k), you pay no taxes on the part of your paycheck you contribute to your 401(k), so you’ll pay lower income taxes this year. You’ll pay taxes on your withdrawals when you retire, which might be a better time to pay taxes (i.e. you might be better able to afford the taxes then). This differs from a Roth 401(k), where your full paycheck is taxed, but you pay no taxes when you eventually start withdrawing your money later.
Carrying debt, especially high-interest credit card debt, causes a variety of problems. Add to that a student loan and vehicle loan, and you can easily be treading water for years.
The more debt you have, the higher your debt-to-available-credit ratio, which lowers your credit score. The lower your credit score, the less likely it is you’ll qualify for a new credit card, car loan or an apartment or house. Even if you do qualify for those things, you might get a more costly credit product. That means you’ll get your card or loan, but at a higher interest rate that might tack on thousands of dollars over the years that you use that credit.
Depending on the amount of credit card debt you have, and the APR on your loans and cards, you could wind up paying thousands of dollars in interest each year. In just five years, you might have generated more than $10,000 or $20,000 in interest payments. Paying down your debt instead of making a 401(k) contribution almost always costs you money in the long run, but can save you from serious financial problems in the short run.
Paying down credit card debt instead of making a retirement contribution is not something you should consider doing just to clean up your debt or give you extra breathing room. Adding just $100 per month to your 401(k) can net you anywhere from $250,0000 to $350,000 (or more) during your 40-year work career, depending on your average rate of annual return. Paying down credit card debt won’t give you even close to that kind of return.
If you can’t pay your bills on time and start missing payments, you have to do a credit-damaging debt consolidation or, worse, need to declare bankruptcy, it’s probably a good idea to temporarily stop making your 401(k) payments and deal with your debt. If you aren’t facing those scenarios, do whatever you can to continue to make your 401(k) payments, and, in some cases, even increase them if you can. You’re probably going to need more money than you think when you retire. As we pointed out in our post, Sorry, But $1 Million For Retirement Doesn’t Take You As Far As It Once Did, some Millennials who retire with $1 million will leave near or below the poverty line.
Keep in mind that paying down debt isn’t the same as paying off debt. Once you’ve lowered your debt enough to give you some breathing room, start making retirement contributions again. The longer you put if off, the more you’ll have to pay later to catch up.
Lead image via Getty
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