Should I invest in my 401 (k) company match or Pay off Debt?
I wrote this article a little over a year ago and decided not to publish it for whatever reason. After writing my most recent post, I decided to dig it all up. Hope you like it, love it, or hate it….Enjoy!
If you have been following along you have noticed that over the last 5 years I have been working my financial independence day off to pay my debt. My goal to pay off my debt meant more to me than anything in my financial life, certainly bigger than stocks, real estate, and retirement. However, during the entire time I was paying off my credit cards, car debt, and student loans I have been contributing to my 401 (k), despite one weak moment Pre-2010. I had over $100,000 in debt and I was still contributing to my 401 (k) to receive the company match, I think not contributing to your 401 (k) is well let’s just say even an idiot like me does it.
I will be the first to tell you that I don’t personally make a ton of money, I don’t give specifics, but I hint towards the median household income in previous posts. If Mrs. Even Steven wasn’t as private, I’d be spilling all the beans about income, expenses, and more. Since I love my wife and prefer to keep the marriage in tact for the long haul, I just hint at my personal numbers. Let’s get started by using the previous linked 2013 Census publication for median household income of $51,939. If you look at the median household income from a previously published white paper*** you will see that the majority of company match programs contribute in between 3-6% and the majority at 75.4% contribute .50 per $1.00 or 1.00 per 1.00. Based on our median income ($51,939) this amount ranges from $1,558-$3,116, me personally I receive a 4% match which is $2,078 per year that every January of the following year my company matches with an equal distribution to my current 401 (k)investment allocation.
Would you pass up on $2,078 per year from your company? Would it make a difference if the money they gave you was tax deferred and put in your 401 (k)? Would your answer be that you are “losing” $2,078 during the year from your paycheck?
Why You Should Say YES to 401 (k) company match
In a Forbes article written by Jeff Rose CFP® listed the 10 Awful 401(k) No-No’s You Should Avoid and “Not saving at All in a 401(k)” as the number 1 in his list. Here’s my favorite part from the article:
“Investing within a 401(k) will help you automatically save for retirement without hardly thinking about it. Before you even have access to your spending money from your paycheck, your 401(k) contribution will be made. Easy peasy.”
While this is my favorite Awful 401 (k) moves to avoid, it does not mention the company match, which is an even bigger blunder than not making a contribution if you have your company matching what you contribute. Eric from Personal Profitability wrote about his friend who had just started a job out of college and did not start her 401 (k)contribution. He mentions she is a smart person, college educated, but could be making one of the biggest long term financial mistakes of her life. While Eric walks you through how to get started with your 401 (k)in his article, I couldn’t take my eyes off the third item in his list.
“Calculate your investment amount. If your employer offers a match, it is free money! Take full advantage. If you can get a 100% match up to 3%, put at least 3%. If you can get 100% match up to 5%, put at least 5%. Do not pass up free money, that would be stupid.”
If you call your HR department or talk with the person helping with your benefit enrollment I doubt they will be this blunt and in your face, so I’m glad you are reading this here. If you are not contributing up to your company match that would be stupid.
Math wins every time and this is where I tell you that Dave Ramsey is wrong. If you are a faithful follower or listen to his podcast every day like I do on my train ride to work, this could be seen as breaking one of the Dave Ramsey commandments.
Let’s get this out in the open. If you are paying off debt you want all of your available dollars to pay off that debt, that makes sense to me. However, what if the amount is small enough and the return big enough that it makes even more sense? That’s exactly what the 401 (k) company match offers. Have you ever considered using the company match to pay off debt? I haven’t looked at the numbers until today, but numbers never lie right!
Example Time with a 401 (k) match and Taking the Money and Run
From above and our median household income and 4% company match we are currently contributing $2078 per year and then every January we get $2078 back in our 401 (k) pockets. Let’s say we break some more Dave Ramsey Commandments and take it all out, the second after it hits our pockets. OH NO, DON’T DO IT!! While I agree this sounds like crazy talk, this is for entertainment purposes only and I want to prove a point.
We immediately take out our company match we received and then are hit with the dreaded but reasonable 401 (k)penalty of 10% from the IRS. So when we pay our taxes we owe the IRS $208 right off the top*, which would leave us with $1870 of that free money we are talking about. After we pay the 10% tax penalty we then need to report this as income, since we are pocketing this money and putting in our personal pockets. There is a couple ways to look at the income we received, but the most logical way is to take a look at our tax bracket and since we make the average annual income we are going to be taxed at 25% of the income we received. Since the 10% is a penalty we actually would calculate the full tax owed from the money received, so we need to calculate $2,078 times the 25%, which gives us $520 in taxes owed. After we subtract our 10% tax penalty again, we ow the IRS $728** from our $2,078 received from our company match. We are left with $1,351** dollars or 65% of what the company match provided.
I want to throw a little more math into the equation because while you just gave contributed 4% of your gross salary, the good news is the money you receive after taxes is not $2,078, in fact if you start with 0% contribution and then increase to 4%, you are only contributing the equivalent of $1,766 or $312 less, try the free calculator here yourself. Might as well add that back into our $1,351** to increase this total to $1,653. The reason for the tax savings is that all of your contributions are contributed before the tax man takes away part of your paycheck forever. Instead of calculating taxes from $51,939, they taxes are calculated from $49,861. Less income to tax, less taxes. The complicated yet simple way to pay the government less money.
So Many Numbers What Does All of This Mean
When you look at all the numbers, you are essentially left with 3 options.
- Do not contribute to your 401 (k), pay the highest possible amount in taxes and pay off your debt
- Contribute to your 401 (k) up to the match, paying less in taxes and use this money to pay off debt after your penalty and taxes
- Contribute to your 401 (k) up to the match, paying less in taxes and leave it there for life
If you are paying off debt, your mind tells you to get all of your money and pay off the debt. Let’s see how much difference it makes in our paycheck and our debt. If you use the free calculator above and calculate the after tax amount for your paycheck, the choice is $1,676 or $1,608. Each paycheck is a $68 difference or .131% of your total annual salary. $68 to pay off debt each month, is this enough to skip contributing to your 401 (k)?
We always hear that we should start early and if you took any finance classes in college you learned that if you contribute early you will be the big winner in the long run. Holding all things the same, we are given 2 options in our battle of $68 a paycheck. If we contributed our 4% for 30 years and received the match after each paycheck(Dave Ramsey calculator I used limited me on this one) or instead contributed our 4% for 27 years or 3 years less it took to pay off our personal debt, the difference is big.
$68 extra today and $280,377 or $68 less and $347,945 or $67,568 difference in 30 years calculated at 6% and if you take it out to 40 years it’s a 6 figure choice.
Choice #3 seems to be yelling at me to contribute to my 401 (k). Choice #1 is being terribly short sided. $68 each paycheck isn’t making a big enough difference to avoid those long term gains. Choice #1 is making the assumption that $68 is paying off our debt that much faster. Maybe we should look at those numbers as well, let’s give them a chance right?
Why You Should Say NO to 401 (k)
The average american household according to a Nerd Wallet article had $16,140. Let’s make the assumption that you are going to pay off your debt on your 20% interest rate credit card in 3 years, well doing so will take a payment of $600 month. If instead you took less the 401 (k)match that you plan and pay $453 it would take you 55 months or 4 years and 7 months to pay off your credit card. When you only take the monthly payment and a high interest rate loan into the equation that makes the decision more difficult. Instead of a $68 paycheck difference, it became a an extra 19 months of paying off debt vs $67,568 extra money in retirement. That decision becomes that much harder. 19 months extra is a long time. 19 months can seem like an eternity when paying off your debt and in terms of dollars and sense the difference in interest paid is an extra $3,101. Despite all of these numbers, it really comes down to a psychological decision more than mathematical.
Math vs Behavior
Remember not every situation is the same, it’s called Personal finance, not Everyone is the Same Finance. Looking at the math, the short term solution is to pay off high interest loans and credit cards quickly, but the long term solution is to contribute to your 401 (k). Both instances only involve math, zero psychological behavior was calculated in this analysis, which as we know makes all the difference in our decisions and what we will actually do.
Personally, I had thousands of dollars in credit card debt and I still contributed to my 401 (k), I couldn’t stand the idea of losing money from my company match, the math and psychologically of it all had me take option #3 and the long term game plan. That does not mean you should follow down the path I have chosen. Honestly, I believe if you have any interest in stocks, bonds, retirement, and numbers then the 401 (k) company match is for you. However, if you are struggling to pay bills and are just in the process making it down the path to financial freedom I don’t fault for you taking a break from your 401 (k), just know that every decisions we make today affects our future. Just like when you bought all of the Christmas presents on your credit card, that had an impact on your immediate satisfaction with presents, but it took away some of your time to enjoy something fun in the future. It could even mean you took a 2nd job to pay off that big Christmas bundle, now maybe little Tommy was smiling when he got his new video game, but are you both smiling when you are working nights to pay off the bill? Did you forget that this step may have led being unhappy at work and you missed the promotion because you were putting 20 hours in every night on top of your current job. It’s hard to do, but look into the future will $67,568 make a difference when you retire? Is this the difference between working until you are 59.5 or 65? Like many of the financial decisions we make on a daily basis it all affects our future.
You know yourself better than I do. When you are making the decision to contribute to your 401 (k), are you practicing paying yourself and paving your path to retire happy or are you looking at losing $68 a paycheck and creating an obstacle for yourself to pay off debt? I came into this post thinking every single person should contribute to their 401 (k)and anything else would be an incorrect decision. What I learned about the 401 (k)match decision is a personal finance decision and not everything can be as simple as everyone should contribute to your 401 (k) today or you are wrong. Mathematically it is the correct decision and the decision I made, but short term and psychologically it could be the decision that gets you to slice through your debt faster than ever before.
One last opinion from a fellow Chicago blogger, The Chicago Financial Planner who I would enjoy meeting one day in his 7 tips to become a 401 (k) Millionaire says to “contribute enough” and he mentions what I have mentioned earlier, there is a difference between “personal finance” and “everyone is the same finance”.
“As a general rule it is a good goal to contribute at least enough to earn the full matching if your employer offers one.”
Looking to make a math decision, then contribute up to your 401 (k) company match. Thinking about this with math and behavior then consider what plan you will follow to the letter. It’s a simple decision, but if personal finance was so simple we would all be millionaires!
One last thing before I go. If your financial life looks like this Men’s bathroom door found at Wynwood Brewing in Miami, then maybe you need a little help.
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*It should be noted I am not a CPA, in fact while I received a B+ in Tax class in college, I still have my good friend do our taxes, he has one of those CPA designations, I recommend you do the same.
**I’m not including any State income tax as everything varies from state to state and this calculation is just enough math to get my point across.
***For whatever reason I can no longer display the document that provided my research, but I swear it’s real:) https://www.am-a.com/pdf/white-papers/wp_match.pdf