Thursday, December 21, 2006

Pay Debt or Save for Retirement

The anonymous blogger over at "My Retirement Blog" discusses this issue .

That blogger gives the example of John Smith, who has mended his spendthrift ways but has a $25000 debt at 15% interest to handle. His employer offers a 401k plan with dollar-for-dollar matching up to 3% of salary. The advice on the other blog is to pay off the debt first before contributing to the 401k plan because the $3750 in interest exceeds the amount that could be obtained from a company match on 3% of salary for those making less than $125K/year.

That math-challenged blogger obviously never graduated as an engineer, or any other profession requiring math skills. It's illogical to give up the 100% immediate return from the company match for a 15% return from credit card debt. Yes, I know that tax considerations can narrow the difference a bit, but not enough to overcome the difference between 100% and 15%. If John Smith is close to retirement and has no tax-deferred savings, he might not pay any taxes at all if he keeps his annual distributions low. Let's take a closer look at the numbers. I use spreadsheets to perform this type of analysis.

In order to save the $3750 in interest over the next year, John Smith need to have $25K in hand to immediately pay off the credit cards. If he did, then what's the problem? Pay off the debt and then participate in the 401K.

To round out the scenario a bit more realistically, let's say John makes $100K per year and has trimmed his expenses so he can devote $2000/month towards improving his net worth. If he applies it all to the credit card debt, after 12 payments he has reduced the balance to $3298, improving his net worth in one year by $21701, and spent $2298 in interest. So John didn't eliminate $3750 in interest payments but reduced it by a good deal.

On the other hand, if he participates in the 401K plan to get the 3% match he reduces the amount he can pay towards the debt not by the $250/month contribution but by less than that because taxes are not taken from the contribution (yet). Say John's marginal combined federal and state income tax rate is 30%. The $250 contribution reduces his take home pay by $175/month. By paying $1825/month ($2000 less $175) against the credit cards, he reduces the balance over the same one-year period to $5548, improving his after-tax net worth by $19451, and spending $2448 in interest.

By participating in the 401k, John's after-tax net worth is $2249 less after one year than it would have been had he applied the entire $2000/month to the credit card debt. But much more than offsetting the $2249 is the $6000 plus any earnings in his 401k account. Yes, John has yet to pay taxes on that money but his tax rate would need to exceed 62% to offset the difference.

The only scenario where it makes sense to pay off debt before participating in a 401K with a 100% match from the employer is if the interest rate on the debt is much, much higher. If John had payday loans, I would recommend he pay them off first.

Priorities should be (in descending order):

  1. Make minimum credit card payments and build up a small emergency fund, say $1000.
  2. Contribute to your 401k to get the company match, even if the match is only 50 cents for every dollar.
  3. Pay off high interest credit card debt.
  4. Contribute the maximum to a Roth IRA, and build up your emergency fund to at least 3 months expenses. In John's case I'd slow down paying on the credit card debt after knocking the balance down and fund a Roth IRA for tax year 2007 by April 15, 2008. Reason being the opportunity cost of not contributing to the Roth IRA.
  5. Consider longer term savings options, such as increasing your 401k contributions if you are close to retirement and have a low balance, or paying a bit ahead on your mortgage if you plan to stay in your house after retiring.

My engineering mindset led me to analyze this a bit deeper than a shot from the hip as the other blogger apparently did, and I came up with a better answer.


Omar Cruz said...
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