Should I Reduce My 401k And Put The Money Toward Credit Card Debt?

Our commenter Datacloud asks,

Given the state of the economy today, is it better for me to reduce my 401k to a minimum and use the extra funds to pay off my credit card debt? This is a good time to put money into the markets, based on my admittedly limited understanding, but with interest rates going through the roof (my personal Chase card went from 12.99 to 23.99), I would like to kick down my cc debt (now at around $6,000) faster. I’m currently only putting 6% in my 401k, and I’m fairly young (35). Have you advice for me?

Does your employer do any sort of matching? If so, keep at least enough of your salary directed to your 401k to earn that free investment money. Beyond that, however, we think it comes down largely to whether or not you’re disciplined enough to see this strategy through to the the end as quickly as possible; it’s probably not going to be worth it if you end up amassing revolving debt again.

If you can stick to the plan, and then re-route everything you were paying on the Chase card into your 401k as soon as you pay off the card, it could work out in your favor. We say this after running some sample numbers through Bankrate’s calculators. We got the idea from former financial planner Gary Foreman at stretcher.com, who suggests using these Bankrate tools to estimate your net worth after n years.

What will it take to pay off my credit card? [Bankrate.com]
401(k) Savings Calculator [Bankrate.com]

Here’s what we did. To keep it simple, we assumed no raises over the next 4 years, as well as no employer matching contribution, and we started the 401k balance at $0. Instead of true net worth, we’re only looking at the total net worth of the 401k after 4 years after you subtract the cost of paying off the credit card.

Annual Salary: $40,000
Currently paying 6% into 401k, or $2400/yr, $200/mo
Debt: $6,000 @ 23.99% APR

Let’s say your current Chase payment is $200/mo. At that rate, it would take 47 months to pay off, and cost a total of $9,400.

Let’s say you cut your 401k contribution in half from 6% to 3% of the 40k salary—in other words down to $100 a month. You added the other $100 to the $200 you were already paying Chase. Under this new $300/mo payment, it would take 26 months to pay off, and cost a total of $7,800.

Now let’s look at how much your 401k would be worth under both scenarios, assuming an annual rate of return of 8%.

If you leave things as they are and contribute 6% a month over four years, your 401k would be worth $11,278.

However, if you dropped your contribution to 3% for two years, but then bumped it up to 12% for the remaining two years, it would be worth $13,448. We say bump it to 12% because we’re imagining that after you paid off the Chase card, you’d have that extra $300 a month that you could re-allocate to your 401k, meaning you could put $400 a month total into it for the remaining two years of this plan.

Scenario 1 (leave things as is):
Value of 401k after four years: $11,278
Total cost of Chase debt: $9,400
Total net worth: $1878

Scenario 2 (temporarily reallocate funds):
Value of 401k after four years: $13,448
Total cost of Chase debt: $7,800
Total net worth: $5648

We fudged a lot on this estimate. For example, we rounded up by 1 month on the first scenario and down by 2 months on the second in order to use the Bankrate tools, which slightly exaggerates the difference between the two final numbers. We also didn’t take taxes into account, since you’ll be paying more if you reduce the amount going into your 401k, and that should slightly work in favor of Scenario 2.

But even going by such rough estimates, you can see that the second scenario is better—IF you can follow a couple of rules to the letter:

  • As soon as you pay off the debt, reallocate that monthly payment to your 401k to make up for the lean times.
  • Don’t rack up any more revolving debt.

Having said all this, you should really run the real numbers and try to be more precise if you want a more certain answer. Or go see a financial planner.

(Photo: dana.ocker)

Comments

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  1. Easton21 says:

    I think this contains a misprint. They gave credit to Gary Foreman, while it was clearly financial guru Gary Coleman who wrote this article. He’s a money wizard.

  2. wcnghj says:

    In addition, the OP should look for an easy-to-get card like the Citi Forward to transfer to.

    0% for 6 months than 12.24% with ontime discounts. .25% every quarter up to 2%.

    • sonneillon says:

      @wcnghj: This isn’t bad if then they don’t use the old card again. Also this article doesn’t bring in the tax advantaged state of a 401k and employment matching.

  3. Sure I could agree with you, but then we'd BOTH be wrong. says:

    Ouch, my head is spinning from all those numbers.

    Where’s the flickr finds? Brain needs rest!

  4. David Thatcher says:

    It’s a great time to put money into the markets until October when the market will go down again, even further than last time. Now is the time to pay your debt off. The stock market will zig-zag up and down but won’t truly recover until 2H 2011- until then, reducing your debt is better than playing the stock market. Now is the time for “deleveraging”.

    • tvh2k says:

      @David Thatcher:
      If only it was that simple… don’t you think the markets have already priced in the impending commercial mortgage crisis? Why 2H 2011? If you chalk this up to the ~5 year business cycle it would be early 2012, but clearly there are other factors in play here. And who knows what effect the nationalization of the financials and auto industry will have on any potential recovery…

      • David Thatcher says:

        @tvh2k: This is more fundamental than the housing crisis. We were never able to fully correct from the dot-com boom because the Fed flooded the market with liquidity leading to easy credit and subprime lending. So now we have to atone for the subprime mess AND finish correcting for the dot-com boom.
        It gets even stickier. The price of oil is a leading indicator of the stock market. The nominal price per barrel in 1990 peaked at 23.19, followed by a recession. The price went down to 15.66 in 1994 bringing in a bull market, and ultimately down to 11.91 in 1998. In 2000, it shot up to 27.39, presaging the recession earlier this decade. In 2002, it bottomed out at 22.81, setting the stage for a recovery until 2005, 2006, and 2007 having prices of 50.04, 58.30, and 64.20, respectively, ushered in 2008.
        Even more relevant is the massive increase in the level of indebtedness of both government and households starting in the Reagan administration. We have maintained our standard of living in the face of falling wages courtesy of Visa and our Equity Lines. Our falling wages are courtesy of inflation. Our inflation is courtesy of the American dollar being worth less. Our American dollar being worth less is courtesy of our trade deficit (and only secondarily to government printing, which is done to counter that deficit). Our trade deficit is courtesy of offshoring, first our manufacturing, then our skilled trades, then virtual offshoring by bringing in H1B visa workers and finally, illegals.
        America’s bill has come due, the writing is on the wall, and the enemy is at the gates. America COULD still make it. We’ve got the raw resources. But only if we BREAK THE BACK of transnational big business. And I don’t see that happening. Corruption is all around us in the form of TARP, PPIP, and endless “credit facilities” like Maiden Lane that are good for nothing but to shore up Bernanke and Geither’s old bosses back at Goldman and their friends. America has become defined by it’s embrace of crony capitalism.
        We’ll have a stock market recovery in 2H 2011, and a general recovery starting in 2012, primarily on the back of healthcare reform and the typical business cycle. But it will be tepid. I fear things are shaping up for a major geopolitical event in 2017-2020 that will define the 21st century. The grass will definitely be greener on the other side but at what cost?

        • deep.thought says:

          @David Thatcher: Golly, with all of your future telling ability I’d expect you’d have made billions in the market! But then… why aren’t you out there using it to fix the problem?

          • David Thatcher says:

            @deep.thought: If only. Look, America got pissed off and flooded Congress with calls demanding a defeat of TARP in the Fall of 08, but the powers that be twisted arms and got their way anyway. Short of a violent revolution (which I am not advocating) I see little chance to break the power of corruption in government.
            The bigger concern is the continued POLITICAL stability of the US. Every thoughtful US citizen should have passports for themselves and their families and sketch out a theoretical emigration plan if things continue to get worse. Consider what country, their requirements, and what agencies can help you get into it.

    • madgoat says:

      @David Thatcher: Shouldn’t that be pay down the CC until the market’s second decline and then redirect in when we retest the March lows? The market feels like its forming a near-term top around the Dow 8700-9000 level right now.

      The next crisis will be the Fed’s balance sheet and inflation. They’ve stabilized the market by buying up CDO’s, MBS’s and other assets and hold them at face value. They issued dollars to banks in exchange to shore up the banks’ Tier 1 capital. What happens when the Fed needs to rein in dollars to prevent banks overleveraging again? Normally they sell securities into the market in order to soak up dollars. What happens here is that no one will buy these things at face value and the Fed won’t be able to soak up as many dollars with them as they initially issued in order to buy them. The result is an implosion of the Fed balance sheet and a resultant massive devaluation of the dollar which will, in turn, cause prices to fly through the roof and interest rates reminiscent of the 1980s. This will more than kill any sort of recovery that we might be starting to move into.

      Not trying to be alarmist, just sayin’.

  5. pecan 3.14159265 says:

    Too. Much. Math.

    Can the OP transfer his balance to a lower balance card or even find a balance free card? That would go a long way to helping relieve his debt load.

  6. pecan 3.14159265 says:

    By the way, thanks for the cat photo!

    • Smashville says:

      @pecan 3.14159265: Indeed. I forgot to thank the Consumerist for taking our request for more cat photos seriously. I enjoy that the kitteh looks to be asking about his 401k…which I assume is in the currency of fish.

  7. TEW says:

    This is not rocket science. The OP should look at the APR and if it is above 3-5% then he/she should stop contributing to the 401 K and pay off the credit card debt. The OP should think about it as a guaranteed return by paying off the debt. It does become tricky when the debt is at 0 % APR. It might be nice to not have to deal with the CC company anymore or the OP can put enough money to pay off the balance in a high yield savings account until the rate changes.

    • GildaKorn says:

      @TEW: It’s not rocket science but it is more complicated than you (and the article author) suggest. You can’t compare the APR paid on a credit card to the return rate on a 401k because of the tax status of each account. Additionally, reducing your 401k contribution by $100 doesn’t mean you have $100 to put in to a credit card. It’s probably more like $70-80.

    • madgoat says:

      @TEW: Also any match by the employer must be factored in as an immediate 50-100% return.

  8. pecan 3.14159265 says:

    Logically, without looking at the math because frankly, I suck at math, I’d have to say that while a 401k will continue to pay out via employer matching, a credit card will continue to accrue interest because of debt and a high interest rate.

  9. spinfire says:

    If your debt is costing you 20% interest and your investments are earning maybe 5%, isn’t the math obvious? Get your debt under control first.

  10. uncle moe says:

    one thing to consider (not sure the likelihood in today’s environment) is to look into a personal loan for $6,000 and get that interest rate slashed in the process.

    a decent credit score should allow for a loan closer to 15% and will make either scenario an easier pill to swallow.

    i’ve done this twice, once after a medical emergency and again after i had a layoff that i wasn’t prepared for financially. not sure how much it saved in the long run, but it does make life a little less chaotic and one major thing it did was disassociate the debt and credit card so i was less likely to rack up more of it.

  11. ExtraCelestial says:

    I’d like to also add that the OP should consider creating a savings fund after he pays off his debt and before he starts to increase his 401K input.

    The fact that he’s having trouble paying off $6k leads me to believe he doesn’t have a lot of liquid money and if that is the case (and yes, I’m doing some assuming) putting all your money into a fee-o-rama if you look at it funny 401K isn’t going to do you a lot of good if you find yourself jobless. Not to mention that employer matching you’ve taken all that time to factor in won’t be worth a nickel.

  12. trlstanc says:

    Whenever any of my friends ask me investment/credit advice I always tell them to take the mental part in to consideration. It’s very easy to wipe out your 401K by promising yourself you’ll pay it all back after you’ve paid off the credit card (or new car/vacation) but a lot of people never will. I always say, just pay the minimum (whatever your employer matches). It’s like the gym membership, you’ll forget about it, and it’ll just keep racking up month after month, but in a good way.

  13. calquist says:

    I would be careful about taking away from retirement. You have to double-dog swear to increase your retirement over 6% after the debt is paid off to make up for lost time.

    • MaytagRepairman says:

      @calquist: I agree. Retirement is really important to me. I hate to see anybody mess with their retirement.

      Like others suggest I would look at ways to get that interest rate knocked down by switching cards or something.

      For only $6,000 I would seriously consider what expenses I could get rid of to save money. I would also seriously consider what I could sell to raise cash even if it means trading my car for a clunker or a scooter and look for an additional part time job on weekends.

      • realserendipity says:

        @MaytagRepairman:
        Ive got to agree with this answer. Get a job, sell everything of value, kill as many expenses as possible, get a roommate and just tackle the debt. 401K and retirement is just something I wont mess with.

  14. Unsolicited Advice says:

    Advisors frequently advise against this, and it has nothing to do with the math. The math, actually, frequently supports paying off revolving debt. It’s because most people aren’t disciplined enough to continue to abstain from revolving debt, and this strategy creates an assumption of the 401(k) as “just another investment” that can destroy one’s retirement.

  15. goodcow says:

    Is an 8% return actually realistic? Isn’t that what got us into this problem to begin with?

  16. jeffjohnvol says:

    Most of the rate raises should have an “opt out” clause to keep the rate at the original – the OP’s card may be different. Of course, when you opt out, they don’t let you make new charges and you would need to get a new card, but so be it. Just my $0.02, which was worth 4 cents 2 years ago.

  17. WisconsinDadof2 says:

    Also, while not a significant factor, 401k deductions are pre-tax. Reducing the contribution amount will raise income tax liability, so it is not a dollar for dollar thing. Depending on the individual’s marginal tax rate, 20% or more of the differential could go to the gubmint.

  18. Trai_Dep says:

    This is way more quantitative than Chris’ usual posts.
    I suspect that Excel Cat, pictured above, deserves to share much of the credit.

  19. Anonymous says:

    Don’t the above calculations ignore the fact that 401(k) contributions are pre-tax? To have an extra $100 of post-tax $$ to put towards your debt, you’d have to decrease your 401(k) contributions by more than $100. Am I missing something?

    That said, I’ve been contemplating a similar move. I have mountains of student loan debt at 6.5+% (already consolidated or private and not able to consolidate) and my employer doesn’t match 401k. Currently I put $500 pretax/month into my 401k. But due to my high taxe rate, that $500 would only be about $300 (after taxes). I think that it’s a closer call as to whether the market will beat 6.5% over the next few years. Any thoughts?

  20. gaywolverine says:

    I am wondering if he already has a 401k and the amount of 401 k loan he could take would cover his balance immediately. He could be out of debt, still pay the same amount into the 401k, plus pay himself the interest through the 401k loan.

  21. Robert Jason Cervantes says:

    I recently took out about 1/2 of my 401K to help pay two credit cards off (C1 & Paypal) along with having some extra cash for vacation. I now only have a recurring $15 coming into my C1 from my XM radio subscription while the Paypal is done with completely. Now I can focus on my remaining balance on my BoA card fully. That card will take me a while to pay off, but at least I got rid of the worry of having 3 payments.

    Overall, you need to set up the discipline first before you go this route. It should not be the beginning, but an extra push in the middle of your journey to being debt free.

    This is a tough decision to make. Which is why I recommend you first try to make it without pulling out of the 401k.

  22. HarlanIshame says:

    Another option is to borrow against your 401k if youre allowed to.

    You set up a payment plan that takes the payments right out of your pay check and you pay yourself back the interest into your 401k. I just took advantage of this to pay off a chase card when they bumped my rate from 8% to 17%. The monthly interest alone on the chase card what about what is costs to repay the loan to my 401k…and I am paying myself the interest!

    • JiminyChristmas says:

      @HarlanIshame: Times being what they are, the big risk to this strategy is what happens if you lose your job. You have to pay back the 401(k) loan within 60 days or it counts as a distribution: which means it’s subject to income tax plus a 10% penalty (assuming you’re younger than retirement age).

      So, let’s say you borrow $20,000 with a 3-year repayment schedule. After a year, you lose your job and the balance on your 401(k) loan is about $13,350. Can you come up with $13,350 in 60 days? If not, you should think hard about taking the loan in the first place. If you’re a median income earner the tax and penalty on the $13K will be about $4000. You won’t have much time to come up with that money either. It will be due when you file your next tax return‚Ķor you could experience the joy of working out a payment plan with the IRS.

      As with many aspects of finance, the 401(k) loan is least risky for those who don’t really need the money, i.e.: those who could afford the total payoff amount at any time.

  23. Grrrrrrr, now with two buns made of bacon. says:

    Kitty!!!!

  24. VWBeetles2 says:

    Suze Orman says the worst thing you can do is take a loan out on your 401K because if you do not pay it back in the short timeframe you have, you are then hit with taxes and penalties if you are not 59.5+ years old.

    I would just stick with the putting in the employer match max and then work to pay down the credit card debt. There are always things in his everyday spending he could cut back on (dining out, frivoulous purchases) that can add up in the long run and he could put towards his CC debt.

  25. Snowblind says:

    I think the math is not taking into account that the difference should be based on what the money is worth when he uses it.

    So the question is, if I don’t put in X dollars now, what will it be worth when I need it at retirement?

  26. ndonahue says:

    I didn’t see mention of this by the OP, but for others thinking about an option like this, don’t forget to take into account any matching funds contributed to your 401(K) by your employer. Decreasing your contribution and losing the corporate match could swing the decision.

  27. BytheSea says:

    Don’t do it. You’ll never make back as much money in your 401k when you’re old as you could have if you kept the money in. Tens of thousands, even over a hundred thousand. Transfer your cc balance to a lower interest card. $6000 isn’t that much, you can probably pay that back within a few years, but it’s unlikely that you’ll have enough discipline to build up your 401k to where it could have been. And, as consumerist says, it’s very likely you’ll incur debt. Don’t commit yourself to poverty in your old age, when you may have staggering medical bills, for a short term problem now.

  28. kolacek says:

    Blah blah blah.

    Quit playing with your calculator, quit making excuses and just pay your damned debts already.

  29. Brazell says:

    The second scenario is kind of misleading unless you really read through the article… which a lot of people may skim . Unless you plan on putting 100% of your credit card payment to your 401k after paying it off (which most people are certainly not disciplined to do), it’ll pay off much more in the long wrong to contribute to your retirement.

  30. comicgeek77 says:

    okay david thatcher. listening to jim cramer and watching loads of financial editorial teevee shows doesn’t make you a market whiz. being able to quote a bunch of idiots word for word who always get things wrong about this mess because you dig their podcasts/radio/teevee shows in no way makes you qualified to give financial advice, you are telling people to avoid investing when prices are depressed and lousy because the prices suck… and telling them to avoid buying until a couple years from now when the prices are likely to be over inflated again… this advice is flat out tarded. why buy coca colas stock cheap now when it will be worth alot more in three years and i can pay more for it? people lose tons investing by following the “buy high/sell low” logic that media pundits push while quoting all the same bullshit excuse lines pundits give for giving bad advice. prices are dirt cheap and things will rebound eventually so its buy time, things may get cheaper but nobody has a crystal ball that can say when things will hit rock bottom. buy low and sell high. nobody can predict how far away the big rebound is or when to sell but buying cheap and selling when you have made a nice profit is how to win. as for as paying off credit card debt is concerened you should never dip into your long term or emergency savings. instead make an honest budget and figure out ways to cut costs and apply it to paying off your debt. start brown bagging it at work, cut down on cable teevee, start using the public library instead of borders/amazon and netflix. start buying the sunday paper and clipping coupons, and apply all those savings towards debt instead of cutting back on investing and saving for retirement. and the most important advice i can give is never listen to cable teevee idiots and people who quote them chapter and verse like the bible online. otherwise you will be buying into bear stearns at fifty dollars a share and writing angry letters to your congressman instead of making money and living responsibly.

  31. Datacloud says:

    I want to thank everybody, especially Chris and The Consumerist, for taking on my question so thoroughly and with a sincere desire to help. There have been many thoughtful and helpful responses. This is why I’ve been a regular visitor to this site for years (maybe since its inception). Some clarification:

    My employer matches 50% of the first 7%. I’m only putting in 6%, so I can’t drop any without losing the match. There are other exigent circumstances: I received a promotion with no raise in pay, a drastically reduced bonus, and am also paying off hospital bills which started at 80K (negotiated down to 25K) and command a total payment of about $600/month. So this debt is not normal. I’d like to think that I have a decent handle on things given the circumstances. 6K in CC debt doesn’t seem like a huge deal compared to what I’ve heard from friends, this site, and elsewhere.

    My credit cards used to have decent rates: around 10-13, which is pretty good for my credit. Now Chase and BofA have both raised my APR to 23.99, for absolutely no reason. I’m never late, carry about 50% of the total balance, and pay 2-3 times the minimum each month. Im not a model consumer by any means, but I’m fed up with the power these lenders hold over me and their abuse of that power in the face of upcoming legislation. I want to take that away from them. My only hope is they don’t close the accounts. I’m not going to get back into this financial picture, but I’d like to have the cards around. One is absolutely necessary for business.

    I’ve decided to drop my 401K to 1% and take the 5% and use it to pay off the cards. Perhaps it isn’t the best thing to do but I think it’s better than taking out a loan on my balance. It should work out to an extra $300/month before taxes. Every little bit helps at this point. I’ll work out the exact numbers later, and let the site know when I have everything paid down. Keep your eyes peeled for an email from me in the Winter/Spring of 2010. :)