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Should you Contribute to a 401k or IRA when in Debt? Apply the 5% Cutoff Rule

Last updated by on January 1, 2016

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)

save for retirement or pay off debtWhen 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?

  1. 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.
  2. 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?

  1. List out your debts, in order, from highest to lowest.
  2. Draw a line at 5%.
  3. 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.
  4. 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:

  1. Put all your money towards Credit Card A, Credit Card B, and the direct unsubsidized student loan, in that order.
  2. 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?

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About the Author
I am G.E. Miller, & this is my story. My goal is financial independence ASAP. If you share that goal, join me & 10,000+ others by getting FREE email updates. You can also explore every post I have written, in order.

  • Danny says:

    Hey G.E.,

    Thanks for that post. As a guy in his early 20s with a bunch of school debt, this is a great post. I’ve been debating how to do that allocation and this clarifies a lot the questions I had about it.

    Currently I am trying a modified Dave Ramsey approach. Putting more than $1000 in an E fund (since my company is for sale). Trying to work up to 3-6 months of living expenses and cashing in on the 401k match.

    Great post. Thank you!

  • Ryan says:

    This is more or less the approach I take as well. I haven’t set a hard and fast rule of 5% (probably because I haven’t had to worry about any interest rates in that middle gray area), but it makes sense. It is worth noting that you carry some additional risk by keeping the 5%.

    Thanks GE! By the way, I hope your theory on average future returns being lower than historical returns is wrong. =-)

  • Syed says:

    Awesome post to an age old question. I completely agree that everyone should take advantage of their company match (and that’s amazing your company matches up to the 401k max you don’t see that too much nowadays). My cutoff is around 5% as well, so I agree with that approach as well. You’re right about it being a personal and philosophical decision. Some people hate debt so much they will want to pay all of it (even low interest ones) before saving for retirement. To each their own I guess.

  • Spencer says:

    I use 3% as my rule, mostly based on the 10 year treasury rate (risk free return). I attack any debts with an interest rate above 3% and make minimum payments on the debts under 3%.

    I also look at the cash flow aspect of debt repayment. I had a loan that cost me $471/month. It was only 2.99%, but by paying that loan off quickly I freed up nearly $500/month of cash flow, enough money to easily max out a Roth IRA account.

    Now to service my student loan debt it’s only $220/month at 2.25%. This is much more manageable and I’m comfortable focusing on investing rather than Dave Ramsey attacking this low interest debt.

  • Max says:

    I don’t think your post takes into account the tax implications.

    Why pay off debt that has ‘high interest’ (compared to the 5% rule) but can help during tax time?

    Shouldn’t you focus more on those that have no tax implications (before the rule).

    How would you balance the priorities between tax implications, loss of potential returns, and ‘guaranteed returns’ ?

  • Lauren says:

    I agree and disagree respectfully with this post. 1) completely agree on your philosophy of maxing out your match benefit. Its free money on the table. Lucky you the match is 50% to max! I get dollar for dollar on the first 3% and 50% of the second 3%. So basically if I need to contribute 6% to receive the full match benefit of 4.5% dollar for dollar. The max for everyone is 30% which is rare, and often more than the IRS max for pre-tax deductions.

    However, I respectfully disagree with your 5% line. To me it is completely contingent on the market, which you are grossly underestimated. (disagreement in philosophy I guess)This year I yielded a 26% rate in my 401k. Obviously this is no 5 year average, but I am so glad I maxed it out. Overall, I am very proud to be 29, have a POSITIVE net worth and have $130K in retirement savings compounding interest and reinvesting dividends.

    I do also agree with the order and priority you recommend paying off credit card debt, (obviously!) yet think Spencer’s point is valid: taking cash flow into consideration. Recently I’ve been helping my husband get out of his massive credit card debts and we used Spencer’s plan to first to free up a $700/month personal loan that had a lower rate than the credit cards. Doing so has helped speed up our pay down plan drastically.

  • Kirby @ TheSimpleMoneyBlog says:

    I think your 5% rule is an interesting way to set a “base” benchmark that people should follow. Of course, each persons’s situation will be a little different from the next and what their immediate goals are (getting an emerg. fund quickly, etc.), but it’s a good start for a rule-of-thumb in looking at the complex decisions so many people face.

    Like you said, for those with an actual 401(k) match, it’s a bit easier of a decision, but for those without a match (or employer sponsored retirement plan at all for that matter), this can be a good guide. I might suggest a slightly higher threshold (6% or so), but with the types of debt that are typically above that threshold in today’s interest rate environment, they’re usually MUCH higher, so picking 5%, 6%, or even 7% may still result in the same thought process. It’s useful too in looking at the balances themselves as even if it’s a lower interest rate, but it could be paid off quickly, then it may make sense to just pay it off, simplify your finances, and be done with it. Again, all that would be best if someone is able to have a one-on-one type of discussion, but for a quick barometer of what to do, this is a good thought process.

  • Virginia says:


    Would you recommend that an older person follow this same rule? More specifics on the situation:

    Individual in their mid-30s. Six figure law school debt at 7%. Maxed out a Roth IRA for the past two years, otherwise no retirement savings.

    I’m just thinking that such large debt will take many years to pay off, even if all extra money goes toward the debt. Someone who is already a bit late to the game on retirement savings may want to factor time into the equation. Five extra years of compounding in a retirement account is worth a lot.


  • Justin B says:

    My problem is not the APR on the debt I owe. It’s that I need every bit of help that I can get right now. I’m fighting a losing battle with my better half’s spending habits meanwhile I’m not spending a dime on myself (paying debt and personal finance is my hobby for now). Not that I mind giving up all of “MY” extra cash towards this. Every time that extra payment time comes around I’m finding it is being cut by 30% due to the budget being shot. THerefore I ended all 403(b) contributions as I need all the help I can get. I plan to pay off all debt (besides house and car) in 1 year and then I will attack the car and start saving.

    Also I’ve seen your articles which mention staying at the same job for too long and unfortunately, where I live there isn’t another option. I am well paid for the area that I live and unless I want to move 2 hours away from family I won’t get any more pay. I live in a very small town and work on the biggest computer network in the surrounding area. Technically I do work out of town as they have asked me to work 2-3 days a week 2 hours away, which pays for my car payment (driving a cheap Ford focus which I will replace with another when it starts to break).


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