Last week I published an article called Dave Ramsey Unleashed. I learned long ago that any post about Dave Ramsey will receive a passionate response from readers. Those that follow his financial teachings do so with “gazelle like intensity,” as Dave would say. One response that I received in both comments and email is that Dave Ramsey teaches that one should stop contributing to retirement savings (whether 401k or IRA) while paying off non-mortgage debt. The question is whether this is the right choice.
The first thing to keep in mind is that there is no “right” choice. There is a reason it’s called personal finance, as a reader reminded me just the other day. That’s not to say that any choice is a good one. But there are almost always more than one reasonable approach to a money management decision. As an example, while Dave Ramsey would stop saving for retirement to pay off debt as would Michelle Singletary, Liz Pulliam Weston believes we should not stop saving for retirement to pay off debt.
With that in mind, let’s walk through several steps that will help you make the best decision for you and your family:
Evaluate Your Debt and Retirement Savings Options
Step 1–Size up your debt: The first step is write down all of your non-mortgage debt and the interest rates you are paying. Credit card debt can easily be at interest rates in the double-digits or even above 20%. Car loans, school loans and home equity lines of credit are typically at lower interest rates. It’s helpful to note the amount of the remaining balance, the minimum monthly payment, and how much of the monthly payment goes to interest.
Step 2–Size up your retirement savings options: Here, the big key is look at any company contribution matches you’re entitled to receive. A typical match might be 50 cents for each $1 you contribute to a 401k, up to 6% of your salary. Some companies will match 401k contributions dollar for dollar, although that is becoming more rare. You’ll want to understand how much money you’ll leave on the table if you do not take advantage of the matching contributions from your employer.
It’s also important to note whether your employer matching contributions vest immediately, or if you have to wait some period of time before the contributions actually belong to you.
Step 3–Calculate your debt free date: It’s helpful to calculate how long it will take you to pay off the debt if (1) you continue to contribute to your retirement, or (2) if you stop contributing to retirement and use the money to pay down debt. Keep in mind that contributions to a traditional 401k are tax deferred. As a result, if you stop making those contributions, you won’t have the full amount to put toward debt; you’ll need to subtract the amount that will be withheld for taxes.
Why step 3? Calculating your debt free date can be a real eye-opening experience. You may be pleasantly surprised or completely depressed.
Making a Decision–Retirement Savings, Debt Pay Off, or Both
To see these steps in action, let’s take a look at the following hypothetical financial situation:
- Household Income: $80,000
- Credit Card Debit: $20,000 @ 15% interest
- 401k Matching: $1 for $1 up to 6%
By setting out this example, we’ve taken care of steps 1 and 2 above. We’ve listed our debt and know what the interest rate is. We also know what our 401k matching contributions will be if we contribute to our retirement. Now let’s look at how long it will take us to pay off the debt.
As a rule of thumb, the minimum monthly payment on a credit card is 2% of the balance plus interest. This does vary from card to card, so if credit card debt is what you’re up against, you’ll want to contact the credit card issuer to see how they determine your minimum payment. But using this assumption, our next credit card payment on $20,000 of debt at 15% would be $487.50. If we continued to make that exact payment each month (even though our minimum monthly payment would decrease as our balance went down), we’d pay off the debt in 58 months, paying over $8,200 in interest.
If you are wondering how I calculated that time period and total interest payments, I used an excel debt reduction spreadsheet calculator. It’s easy to use, very flexible, and free. Here’s the link to check it out.
Now let’s assume that instead of contributing 6% to retirement (which would total $4,800 on $80,000 in income), we put retirement savings toward the debt. Since we’ll have to pay state and federal taxes on the $4,800, let’s further assume that we’ll actually take home $3,840 of this amount (after 20% in taxes), or $320 a month.
Using the spreadsheet debt reduction calculator, the extra $320 reduces the time to pay off the debt from 58 months to 30 months. It also reduces our total interest payments from about $8,200 down to about $4,100. During the 30 months to pay down the debt, you would have given up 6% matching contributions totaling $12,000.
We can now compare the results between paying the debt off in 58 months while we contributed to our 401k, with paying off our debt in 30 months by forgoing retirement contributions. Here’s how it looks:
|Retirement + Debt||Debt Only|
|Retirement Savings (Months 1-30)||$24,000||$0|
|Retirement Savings (Months 31-58)||$22,400||$22,400|
|Extra Savings (Months 31-58)||$0||$13,650|
|Total Savings – Interest||$38,200||$31,950|
A few things about these numbers. First, investment gains or losses have not been factored in. Second, the $13,650 for “extra savings” represents the amount that was being put toward the debt. Once the debt is paid off, that amount can go to savings.
At first glance, the numbers seem to strongly support continuing to contribute to retirement while paying down debt. The difference of $6,250 is a lot of money. But one thing to keep in mind is that the retirement contributions eventually will be taxed. Assuming a 20% state and federal tax rate, the extra $24,000 put towards retirement in the first column of numbers will eventually get reduced by 20%, or $4,800. Factor that tax into the math, and the difference between these two options is a lot smaller.
Making a Decision–Retirement, Debt or Both
When all is said and done, here are the things to consider:
- Matching Retirement Contributions: The better the employer match, the more likely one should continue to save for retirement to take advantage of the match. If there is no employer match, focusing on debt is often the best choice. Even with a dollar for dollar match, if the interest on debt is high enough, the decision may still be a close call.
- Debt Interest: The higher the interest rate on debt, the more likely one should stop saving for retirement until the debt is paid off. If the debt is on no interest or low interest credit cards, low interest home equity lines, or a low interest school loan, than continue to save for retirement while paying down debt becomes a better and better option.
- Be Honest: Before putting a stop to retirement savings, be hones with yourself about debt. One of the worst outcomes is to stop saving for retirement to pay down debt, only to find yourself going into more debt. If you’re not serious about getting out of debt, or you think there is a good chance you’ll charge the cards back up once they are paid off, keep saving for retirement.
- Time to Pay Off Debt: For those with debt that will take many years to pay off, putting retirement savings on hold may be a bad idea. It’s one thing to stop saving for retirement for a year or two. But we all know that the key to successful retirement savings is to start early.
- It’s Not All or Nothing: Keep in mind that you can compromise. Rather than saving nothing for retirement or contributing enough to get the full company match, you can meet in the middle. You can contribute some to retirement, even if it doesn’t take full advantage of the company match, and put the rest toward debt.
In our case, the non-mortgage debt we have is at very low interest rates. The highest interest we currently pay, after taxes, is about 3%. On top of that, my employer matches 401k contributions dollar for dollar, and the matches vest immediately. So we’ll keep saving for retirement while paying off debt.
So how do you make this decision?