Should you Contribute to a 401k or IRA when in Debt? Apply the 5% Cutoff Rule
One of the most common financial topics brought up at the work lunch-room table (or really anywhere, now that I think about it) centers around the old save for retirement vs. pay off debt debate.
The topic usually starts as a question similar to this:
“What percent do you guys contribute to your 401K?”
“How much of the company match do you get on your 401K?”
Whatever answer I or anyone else gives is usually irrelevant to the asker. So I usually follow up with a question of my own, “That’s a good question, but why do you ask?”
After a digging a little deeper, it never fails that the reason the person is asking is because they are not sure whether they should be putting more towards their retirement or paying off some of their auto, credit card, student loan, mortgage, or other unenviable debt.
It really shouldn’t come as a surprise that this is a top of mind question. Young professionals are almost always in debt and have negative net worth. At the same time, they have 401K’s or IRA’s for the first time ever. Prioritization of what to do with additional income isn’t always the most intuitive, even if the percentages are. It’s a confusing place to be in, financially speaking.
Sometimes the Answer is Obvious (High Employer 401K Match)
When this question comes up at my place of employment, the answer is almost always obvious to me.
My employer matches 50% up to the 401K maximum. The correct way to look at an employer match is as a guaranteed return on your investment. A 50% match equates to a 50% return on investment. Only 2 years (1933 and 1954) in the history of the S&P 500 (and it’s predecessor) have seen annual returns eclipse 50%, and the average return over that time is just under 10%. A match is guaranteed returns vs. a 1-in-50 prayer.
What does this mean?
- For starters, always take the guaranteed returns of a 401K match vs. instead opting to contribute to an IRA and hoping for good returns. ALWAYS.
- Beyond #1, compare the match to the APR on the debt owed. Unless the mafia, or worse, payday loan providers, are chasing you down to collect their 500% APR returns, you take the 401K match vs. paying off lower APR debt. That’s free money. And 50% return eclipses just about every type of debt APR, including credit cards, by at least 25-30%.
What About After the Match? I Use the 5% Cutoff Rule
After the match (which usually addresses this question for 90% of the population, because most are not taking full advantage of their employer match)… it gets a little tougher.
My general rule of thumb for this is formed from a muddy mix of history, convenience, philosophy, and a strong distaste for personal debt.
I look at that historical S&P 500 return of 9.7% and cut it approximately in half (to 5%) in order to get a benchmark to compare future investment returns to debt APR’s. I call it The 5% Cutoff Rule.
Why 5%? This is personal opinion, but I don’t think that future returns are going to be as good as historical returns. Most of the big/easy economic gains (phones, electricity, radio, television, national highway infrastructure, vehicles, planes, extraction of cheap fossil fuel, the factory line, robots, 40-hour work weeks, mobile phones, computers, internet, cheap data storage, house for every family, 2 cars for every family, government debt, electronic payment) have been played out. Those inventions led to outsized gains in consumer spending and economic activity. On top of that, there are many roadblocks staring us right in the face that could have negative impacts on returns: global warming, political gridlock, peak oil, Chinese housing bubble, wars, Euro-zone crisis, bond bubble, derivative non-sense, etc. etc.
There’s a lot of philosophy in that statement, which you may or may not agree with. But here’s one you can’t disagree with: paying off debt results in guaranteed returns (in the form of savings), while investing returns are not guaranteed. And when that debt is compounding debt (i.e. credit cards), the savings are even higher.
So how does the 5% rule work, in action?
- List out your debts, in order, from highest to lowest.
- Draw a line at 5%.
- Pay off debts above the 5% line (in order from highest APR to lowest), until you can’t any more, before putting additional funds towards retirement.
- Save for retirement with the rest of your monthly income (IRA first, then 401K), while paying off the standard monthly payments (to avoid fees and more debt) on debts under the line.
This rule assumes you have an adequate emergency fund and no other big upcoming expenses.
So let’s look at how this plays out with some example rates:
Credit Card A: 20%
Credit Card B: 15%
Direct unsubsidized student loan: 6.8%
————————————————- 5% line
30-year mortgage: 4.5%
Direct subsidized student loan: 3.8%
In this example, you would:
- Put all your money towards Credit Card A, Credit Card B, and the direct unsubsidized student loan, in that order.
- Once debts in #1 are paid off, put your remaining monthly income towards retirement, while paying the standard payments on the 30-year mortgage and direct subsidized student loan.
Note that this rule could easily change to 6, 7, or even 10% or more in a high-interest environment (like most of the 1980′s). But in a low interest environment like we have today, it works.
This rule may seem over-simplified for mass appeal, but it works just fine for me.
What rule do you use to prioritize debt and savings?