Q: With the extra money I have, should I focus on paying off debt or contributing to my 401(k)?
A: The short answer is “Yes.”
In other words, do both.
The inability to both reduce debt and to contribute to a 401(k) or IRA has consequences to you. Are you 100% sure it’s one or the other? Look at your budget again. Where can you tighten further? Can you make some lifestyle changes that will allow you to come up with additional money?
Let’s assume you’ve made the hard choices and you are living on a really tight budget. And there’s only enough left over to do one or the other.
Accelerating the reduction in high interest rate debt needs to be a priority—and we emphasize “high interest rate debt”. Your house mortgage and car debt, if at reasonable interest rates, should not take priority over contributing to your 401(k). As soon as your budget allows, contribute to your 401(k) the minimum amount that will get you the maximum Employer match.
Do you want to miss out on matching contributions if your company offers them? Let’s assume, one, there is a 50% match and you make a tax-deductible contribution to your 401(k); and two, your marginal federal and state tax rate is 20%. If you contribute $100, you save $20 in taxes and get a $50 match. Thus your $80 out-of-pocket contribution results in $150 being put into your 401(k) account. Not bad!
The challenge to accumulate enough money for retirement is great enough without missing opportunities to receive matching dollars and to have your savings compounding in a tax-favorable manner over long periods of time.
Even with your focus on paying off high interest rate debt, make a small contribution—even if only $10 a month—to your 401(k) just to get in the habit of it. There’s the ancillary benefit of learning about investing.
It’s a balancing act. Psychologically, debt is grinding. In summary, our advice is:
Do everything you can budget-wise to maximize discretionary income.
Focus on paying off high interest rate debt as quickly as you possibly can.
Make a small contribution to your 401(k), even if only $10 a month.
Once the high interest-rate debt is paid off, build up an emergency fund.
Start contributing to your 401(k) the minimum amount to receive the maximum employer match.
Commit the same austerity to 401(k) investing AND maximize those contributions. Remember, you have lost opportunity to make up for.
Having learned a hard lesson, vow never again to get burdened by credit card and installment debt.